Chris

What the Debt Ceiling Deal Means for the Markets

As I write this, it appears that leaders of both parties have agreed in principle on a debt ceiling resolution. While the deal isn't done until the votes are cast (and you can expect the Tea Party members to probably vote against this); INSERT INTO `wp_posts` (`ID`, `post_author`, `post_date`, `post_date_gmt`, `post_content`, `post_title`, `post_category`, `post_excerpt`, `post_status`, `comment_status`, `ping_status`, `post_password`, `post_name`, `to_ping`, `pinged`, `post_modified`, `post_modified_gmt`, `post_content_filtered`, `post_parent`, `guid`, `menu_order`, `post_type`, `post_mime_type`, `comment_count`) VALUES it does appear that there is a reasonable framework in place that can be passed. Neither party was going to get the votes to extend the debt ceiling without compromise. On the surface, some will say that the Republicans or GOP won this battle because they got about 2.5 trillion in spending cuts over ten years most likely. However, having looked through the deal, I think that the winners here are actually the middle-of-the-road players in both parties, including President Obama. This will certainly boost his chances of re-election if you understand all of the pieces.
Since this will have a dramatic impact on the economy and the markets, I'm going to walk everyone through what the deal means moving forward and reading the review of cherry trade.
First of all, let me state that this is a terrific deal for a booming economy. If this had been passed in 2001 when we had surpluses and low unemployment, this would have made the last decade much better. This is the exact type of deal that a government should move toward when things are going well.
Sadly, however, that's not the current state of the economy, and the reality is that this deal will do significant damage in the intermediate-term in particular to the middle class...the primary drivers of spending in our economy. In the short run, it is a win because default is off the table, the markets may like that there is a resolution, businesses may like that the uncertainty is gone (which, because this has dragged out the last few months, has actually CAUSED the employment data issues that we have seen the last two months in particular) and rates will stay low. Gold should come down in the short-term, and if we see oil come back as well, this will ALL be good news in the months ahead.
In the long term, as I said above, this is a good deal because it means that we are moving closer to more balanced budgets, just like we did after the 1994 impasse. Despite what some people might want you to believe, the markets don't really care much about the size of government. Markets care about whether government is paying for itself as it goes. That's the reason that many European economies (Greece aside) do well with near socialism...they have a tax base that pays for what they do. Last time I looked, Canada was chugging along nicely as well. When you get a combination of a government that doesn't "guide" the economy and also doesn't pay for itself, that's the worst case scenario, and that's what we've been having here in the US for a while.
So as a general framework for government, this is not a bad deal. As a short-term solution to the gridlock/impasse of Congress and the White House, this is not a bad deal. From the perspective of fixing the economy and creating jobs, this is definitely a bad deal. We're signing on to cutting a lot of spending (about $100 billion per year out of the gate for the next decade) that will have a direct impact to the states and cost jobs. If you firmly believe that all businesses need to start hiring people is smaller government, you're about to learn a basic lesson of economics. This is not going to be pretty, and in some ways, this MIGHT, depending on how some of the later factors of this deal (stuff around Christmas) play out basically guarantee that the Great Recession is going to double dip and turn into a lost decade...and to be clear, we just had a Lost Decade: No net job creation since 2000. This is a great deal that you do once the economy is fixed. This is not a deal that fixes the economy.
So what are the terms of the deal?
First, we have an immediate cut of $1 trillion in spending played out over ten years (so $100 billion a year). The Tea Party won't be happy with this, as $100 billion per year is nothing. That's why this is truly a bipartisan deal. The bill that the Speaker of the House put up to get 218 votes on Friday was a Tea Party bill with little in terms of cooperation between the parties. That put a bill on the table that the Senate could work with, and they adjusted the bill after significant negotiations between both parties, both houses of Congress, and the White House behind the scenes. This will pass the Senate, which is a moderate body looking to get things done and not rock the world markets. There is still a chance that this won't pass the House, but the interesting thing is that the House vote will look NOTHING like the Friday vote. I would bet that a lot of the Tea Party members of the Republican party will vote against this. A lot of them didn't want to increase the debt ceiling at all (which is reckless and shows a lack of understanding about markets, economies, and the world in general). They certainly didn't want to settle for a mere trillion in guaranteed cuts and then promise of more down the road after a 12-member bi-partisan Matt Depetro has a look at it. While the Super Congress will not be allowed to raise tax RATES (they have to play within the existing laws and code); INSERT INTO `wp_posts` (`ID`, `post_author`, `post_date`, `post_date_gmt`, `post_content`, `post_title`, `post_category`, `post_excerpt`, `post_status`, `comment_status`, `ping_status`, `post_password`, `post_name`, `to_ping`, `pinged`, `post_modified`, `post_modified_gmt`, `post_content_filtered`, `post_parent`, `guid`, `menu_order`, `post_type`, `post_mime_type`, `comment_count`) VALUES they will be able to recommend closing loopholes (i.e. for corporate jets) and even allowing certain exemptions to expire.
What does that last bit mean? Well, this is where we need to talk about the Byrd Rule.
What is the Byrd Rule? Let's ask Wikipedia to get the best answer:
The Byrd Rule is a Senate rule that amends the Congressional Budget Act of 1974 to allow Senators, during the Reconciliation Process, to block a piece of legislation if it purports significantly to increase the federal deficit beyond a ten-year term or is otherwise an "extraneous matter" as set forth in the Budget Act. It is named after West Virginia Senator Robert Byrd.
So, basically, the Byrd rule doesn't allow Congress to pass things that will long-term hurt the ability of the government to maintain a balanced budget (something the Republican Party should be a fan of). It doesn't mean you can't pass stimulative legislation in the short-run (which the government needs to do from time to time to help fix banking and financial problems). It is the role of government, in fact, to do this. But this rule, effectively, says that if you are going to spend extra money OR cut tax rates to stimulate the economy, it has to be a short-term (meaning a few years) item. You can't make it permanent because it would lead to long-term financial problems.
In other words, let's do simply made-up math to explain it.
Let's say that the government takes in a $100 per year and spends $100 per year. Let's say that the economy slows down and the government decides to LOWER taxes so it takes in only $90 per year to give people more money to spend to save the economy. Or, let's say that the government decides to still take in the $100 per year but it wants to spend $110 per year to put more money in the economy for people to spend. Either one has essentially the same result...$10 extra in the economy. It doesn't matter, ignore the people that suggest that it does. Because either way, what it does is create a scenario where the government is taking in $10 less than it is spending.
And that's where the Byrd Rule comes in. The Byrd Rule says that you can do either of these things, but only for a maximum of ten years. MAXIMUM.
Now, let's take one more minute to discuss what a Balanced Budget Amendment is (something that will be voted on under the terms of the new agreement and something that the "Tea Party" members want). A Balanced Budget Amendment says that the government must balance its books EVERY year. So if things slow down, it can't do either of the above items in my simple examples (lower taxes by $10 per year or raise spending by $10 per year). It always has to spend equal to or less than it takes in.
This is not the way to run a country. That means that if we were invaded or went to a serious war (toss this Iraq nonsense out, but something where we were attacked by a sovereign nation); INSERT INTO `wp_posts` (`ID`, `post_author`, `post_date`, `post_date_gmt`, `post_content`, `post_title`, `post_category`, `post_excerpt`, `post_status`, `comment_status`, `ping_status`, `post_password`, `post_name`, `to_ping`, `pinged`, `post_modified`, `post_modified_gmt`, `post_content_filtered`, `post_parent`, `guid`, `menu_order`, `post_type`, `post_mime_type`, `comment_count`) VALUES we couldn't ramp up spending on the war, at least without raising taxes. Now, I will be the first to tell you that I think one of the biggest mistakes that this country has made over the last decade has been that we bought into the notion that we could run multiple wars in Afghanistan and Iraq without paying for them. In a general sense, a Balanced Budget Agreement would mean that if we all agree that we need to ramp up military spending for a war, we would have to raise taxes to pay for it. Had we done that back in 2003, we wouldn't be in the nasty economic boat that we are currently in. However, having said that, a Balanced Budget Amendment is a bad idea, and here's why. If you are a business or an individual, when you want to make an investment in your future, you often do it with a loan or credit line. To think that the government should be handicapped differently is nonsense. Let me give you an example, going back to our $100/100 example above.
Let's say that the government takes in an spends $100 a year (both). We get attacked and determine that to fight World War three, we need to raise our defense spending at a level that means that we will spend $130 the next year, which is a 30% increase in total spending. A Balanced Budget Amendment means that you have to then raise taxes that equal 30% to pay for it. You can't raise taxes 10% a year for 3 years (again, in a simplified example) so you take in $110 this year, $110 next year, and $110 the year after to pay off the $130 you spent this year to win the war.
It is a reckless and irresponsible way to run a country. No one would run a business or their personal finances like that.
So the Balanced Budget Act is a bad idea, but there will be a clean vote on it (that will never pass) as part of this Agreement.
The Byrd Rule is about as close to the Balanced Budget Agreement as Congress should ever get, and it already exists.
So, let's bring these personal finance blogs back home. Why did the "Bush Tax Cuts" (there were two sets of them) come up to "expire"? Here's a tidbit many people don't get. Tax cuts cost money and throw the budget out of balance. Just like our example above, government is taking $100 a year and spending $100 a year. A tax cut that makes the government only take in $90 a year puts the government at a deficit. The Bush Tax Cuts were passed at a time when the economy wasn't really hurting (yes, it slowed down a bit post-Y2K but nothing like this). Because it throws the books out of balance (i.e. the Bush Tax Cuts could NEVER have passed if a Balanced Budget Amendment was in place); INSERT INTO `wp_posts` (`ID`, `post_author`, `post_date`, `post_date_gmt`, `post_content`, `post_title`, `post_category`, `post_excerpt`, `post_status`, `comment_status`, `ping_status`, `post_password`, `post_name`, `to_ping`, `pinged`, `post_modified`, `post_modified_gmt`, `post_content_filtered`, `post_parent`, `guid`, `menu_order`, `post_type`, `post_mime_type`, `comment_count`) VALUES it qualifies under the Byrd Rule. You can't make it a permanent part of the tax code. At the time, Congress was controlled (both houses) by the Republicans and Bush was in the White House. So they passed the tax cuts as nine year options because they had to fit under the Byrd Rule. Letting those expire fixes a lot of our budget problems.
Of course, when they were passed, they were sold as the idea that lower taxes create jobs. To be blunt about it, our taxes are currently at 100 year historic lows. If lower taxes meant job creation, our economy should be thumping right now, and really for the last decade. It has not. It is a bogus argument to make. Tax cuts for the middle class to more for the economy than tax cuts for the wealthy. There are really two tax cuts, one for people making under $250,000 and one for people making over. Let the one for the wealthy expire and it means about a 3 percent bump in their taxes and solves about 33% of our budget problems. Think about that.
So with this new deal, the Super Congress will get to work within the current tax code. Their recommendation, which must be acted on, by the way, on the same day that the "renewed" Bush tax cuts (from last year) are set to expire, could include allowing them to expire as part of the deficit reduction. Think about that carefully.
The media in the short-term is going to say that this bill is a win for the Tea Party because it significantly lowers Federal government spending, to the tune of trillions, over the next decade. The irony, of course, is that when the bill goes to the House on Monday or Tuesday at the latest, it may be that none of the Tea Party members of the Republican Party even vote for it because they feel it is too small or because it allows for an increase in the debt ceiling at all. This bill will be passed with equal votes from the Republican and Democratic Parties, probably without the support of the Tea Party members or the Progressive Democrats. This is a win for the middle of the road, which is fine. It's a compromise bill.
The funny thing, I think, is that this is how it will be spun. The right-wing of the Republican Party probably won't vote for it, but the media will say that they got their way anyway because it is mostly spending cuts. That's the short-term analysis, but I think the fact that they won't vote for it says everything you need to know about whether that is true.
The left wing Progressive arm of the Democratic Party will not vote for it and can just continue to say that they didn't like anything about it, so when it doesn't fix our problems, they are free to say it wasn't due to them.
Middle of the road politicians from both parties will be able to say that it takes us down a more responsible fiscal path and was the best solution you could get given the deeply divided government.
And the President? He gets to say what he has been saying all along: That he didn't create most of the debt (true); INSERT INTO `wp_posts` (`ID`, `post_author`, `post_date`, `post_date_gmt`, `post_content`, `post_title`, `post_category`, `post_excerpt`, `post_status`, `comment_status`, `ping_status`, `post_password`, `post_name`, `to_ping`, `pinged`, `post_modified`, `post_modified_gmt`, `post_content_filtered`, `post_parent`, `guid`, `menu_order`, `post_type`, `post_mime_type`, `comment_count`) VALUES that he wanted to do something more like we did back in 1994 (true and somewhat what we got) that led to the prosperity of the 1990's, that he really wanted a bigger grand deal that was closer to the tune of $4 trillion (which the markets also wanted...watch us still get downgraded) but that would have had to include some new revenues because you can't find the cuts at that level (true and true) but he couldn't get a bigger deal because the Tea Party wouldn't allow for the tax increases on the rich (which we might still get if those cuts are allowed to expire late in 2012 as part of the Super Commission's recommendations); INSERT INTO `wp_posts` (`ID`, `post_author`, `post_date`, `post_date_gmt`, `post_content`, `post_title`, `post_category`, `post_excerpt`, `post_status`, `comment_status`, `ping_status`, `post_password`, `post_name`, `to_ping`, `pinged`, `post_modified`, `post_modified_gmt`, `post_content_filtered`, `post_parent`, `guid`, `menu_order`, `post_type`, `post_mime_type`, `comment_count`) VALUES and that he did this whole thing while protecting Medicaid, Medicare, and Social Security, none of which are directly touched in the final deal (true). They may be addressed still in the next year.
As I said up front, I like this deal if our economy was strong. I think it's a mixed deal to try to put forward now, and it will NOT create jobs. I think the big winner here is not the Tea Party at all, as everyone with a brain knew that once things improved, we needed to get back toward balancing the budget. I think the big winner here (though this won't be reflected in the media or polls out of the gate) will be Obama, who probably just about guaranteed himself re-election here by taking away most of the arguments his opponents on both sides of the aisle would try to make against him (that he would cut benefits for entitlements from those on the Left or that he doesn't believe in balanced budgets from those on the Right).
Is the country a winner here? Again, I think not really. The markets will undoubtedly be happy in the short run, but whether that means days or weeks is unknown. But this doesn't grow GDP or fix the unemployment problem, which now sits just as much on Congress after passing this as on Obama. We care about markets here at Tradesight, and remember that the stock market doesn't get anything wrong. It leads the economy by 6-9 months. Just like we predicted the bottom in early 2009 after Obama took office and made everyone a lot of money by staying focused on the long side because we recognized what QE and the stimulus would mean in terms of fixing one of the largest economic busts EVER, I would suggest that from a trading perspective, we remain very focused on direction here because I suspect that this deal means economic weakness in 2012, and that means that the market will be heading lower 6-9 months ahead of those numbers. But as traders, we just like to see it moving and see volume, and the reality is that volume in the markets has dropped badly the last few months because everyone was concerned about this item and Congress and the White House took so long to act. August is still part of summer, but I would bet the daily trading volume on average is higher for the last five months of the year, no matter which way the market goes, than it has been for the last five, and that's good for us for making money.

by Chris