X-Date Fast Approaches

Amazingly, on nothing more than the hope that US leaders would come together to extend the government debt limit, the S&P500 jumped 0.75% last week on low to moderate volume. As usual the investing public ignored this move; most of it was accomplished by high-frequency trading shops that drove the price higher on news of possible deals in Washington DC.

Was any deal actually reached by Friday evening? Or Saturday? Or Sunday? Nope, nothing was accomplished, and no deal even loomed on the horizon. But that still meant that what would normally have been another losing week in the stock markets, suddenly became a winning week.

What about fundamentals? Again, these seemed to matter less and less. While corporate earnings estimates continue to me slashed at horrific rates, US economic data continues to paint a picture of a stalling economy. Last week, most major news was not announced due to the ongoing “partial” (partial because only about 15% of the federal government is actually affected) federal government shutdown. But initial jobless claims absolutely soared; at 374 thousand, they rose at the greatest rate in several years. Consumer sentiment also missed expectations. And consumer credit—specifically credit card debt, the debt not fueled by US government programs (such as student loans and auto loans)—continued to decline, as it has been doing for the last several months.

While notable, last week’s rise in the S&P did not break the down trend on the weekly charts. For that to happen, the S&P would have to break out to new highs. And even the daily charts, which showed a massive reversal have not quite turned bullish. For that to happen, the S&P will have to follow through with positive days early next week. Also of note, several measures on market internals did not match the euphoria in the headline price increase. New highs minus new lows continued to deteriorate. The percent of stocks above their 150 day moving average also barely changed. And the NYSE summation index turned down rather dramatically. These internal breadth signals suggest that more selling could be around the corner.

Finally, the amazing part about the debt ceiling issue is the potential for massive fireworks if there’s no resolution. The absolute deadline, according to Treasury secretary Jacob Lew is October 17, which is only days away. This is the X-Date.

What happens after this if no deal is reached?

While nobody knows for sure, mainly because there’s no exact precedent in the US, the consensus is—-lots of bad stuff.

The most common view is that the Treasury will be forced to prioritize payments. This means that it will pay what it deems to be the most important payees first, with funds it actually has, and simply delay payments (creating a form of an IOU) to those payees that it deems to be less important.

The problem is that the global financial markets, never having to face such a problem which involves the global reserve currency and possibly the US Treasury market, may start to get scared.

And when financial markets get scared, the most natural thing to do is to sell. And if selling starts, especially when many assets in the US are near record highs (think stocks). then the selling can quickly turn into an ugly panic, pushing prices down much further than rational analysis would suggest they ought to fall.

The good news is that we don’t have to wait very long for this to play out. Tick tock.

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