Wall Street's Wake-Up Call

Written by Steve Bell on Monday April 18, 2011

Neither President Obama's deficit reduction plan speech nor Congress' response seem to have settled market fears about America's soaring debt.

This morning Standard and Poor’s put its long-term rating on United States sovereign debt on negative outlook.  The equity market, as I write, is off by more than 200 points on the Dow and 50 points on the tech-heavy NASDAQ.  Strangely, markets seem to be reacting as it they didn't expect this or couldn't divine it by simple research.

Three things seem to have reached a synergistic point:

First, markets are spooked by the continuing European debt crisis.  Almost all bond holders, including those European banks heavily exposed to Greek, Irish, Portuguese, and Icelandic debt, now realize the near-certainty that some kind of "punishment" in the form of re-structuring all that debt seems inevitable.

Second, the markets seem to realize that political uncertainty in North Africa and upcoming elections in China could mean dramatic changes in important global financial and economic sectors.

Third, neither President Obama's deficit plan speech nor Congress' response seem to have settled market nervousness about projected soaring American debt.

But I wonder why markets have not expected this?  None of the three fact patterns offer new information.  All have been subject to hundreds of analyses and hundreds of thousands of words and numbers the past two years.

Two things seem likely to happen in response to the S&P announcement.  First, most Americans won't notice -- especially with $4 a gallon gasoline and a 9 percent unemployment rate.  Second, politicians will issue strong warnings, but will engage in weak action.

The timing of the S&P announcement may have caught markets by surprise, since many analysts thought that the firm would have released any such statement after the 2012 elections.  It may well be that S&P hopes that announcing at this time might prod politicians in Washington, D.C., at a time when the President, the House Republican majority, and a bi-partisan group in the Senate have begun to commit to real negotiations on deficit and debt reduction.

I still believe that the odds are less than 50-50 that Congress and the President will come up with a convincing plan this year.  And, 2012 seems the least likely year for such an initiative.

However, if the S&P announcement is taken as a warning -- like the dead canary in the mine shaft -- those odds may improve.  Rhetorically, at least, the two sides are far apart on every aspect of long-term debt reduction.  In substance, however, I believe that common ground can be found on most points.  The single most important person in the fight ahead is still House Speaker John Boehner.  No one has a tougher job in Washington, D.C. than the Speaker, who’s trying to forge his caucus' desire for smaller and less expensive government into something beyond mere sloganeering.

The two-week Easter and Passover recess comes almost providentially.  Members can hear from constituents back home, rhetoric from the budget combatants gets time to calm, and the Senate Gang of Six gets renewed impetus with their colleagues.

For those who have been saying that markets will simply ignore all the Congressional and Presidential nonsense and bargaining statements, the S&P announcement comes as a reminder of what I have written about before.  Out in the marketplace exist bond traders.  They are watching.  They will watch all the silliness surrounding the debt ceiling fight a couple of months from now and either find themselves re-assured or find themselves heading for the exits.

Some commentators have responded that: "Markets know that the debt ceiling will be raised.  They won't be spooked."

I’ve worked with 31-year-old bond traders.  When I was at Salomon Brothers in the l980s and 90s, Salomon was the biggest bond house in the world.  When you have more than 500 bond traders on one floor, connected to their colleagues in London and Tokyo instantaneously, exhilaration and panic both move at warp speed.

If Congress passes two or three short-term increases in the debt ceiling, following the pattern of behavior that characterized the Continuing Resolution negotiations, then those young bond traders may start moving quietly toward the exits...and none of them will want to be the last one out.