Fed, Debt Ceiling, An Obscure Factor for Markets

David R. Kotok
Tue Oct 5, 2021

“Congress is at an all-too-familiar stalemate over raising the federal debt ceiling, worrying bankers and others that the financial markets could take a hit if lawmakers fail to reach a deal in advance of an October deadline.”
(“Why debt limit standoff could be worrisome for banks,” https://www.americanbanker.com/news/why-debt-limit-standoff-could-be-worrisome-for-banks)

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Cumberland Advisors Market Commentary - Fed, Debt Ceiling, An Obscure Factor for Markets by David R. Kotok


Recent stock and bond market turmoil has been blamed on a lot of factors. Today we want to add an obscure but very serious factor to the list. It is a never-before-used Fed policy response that a debt ceiling-induced default might trigger.

First a recap. Many folks looked at recent market volatility in stocks and in bonds and  thought that it is driven by uncertainty about Fed governance composition: the unknown circumstances of J. Powell’s reappointment (or not); Quarles’s departure; Kaplan’s and Rosengren’s early retirements; or Clarida disclosure. Or by tapering or prospective inflation rates. Others think market gyrations are due to China and Evergrande. Still others attribute volatility to the economic slowdown — maybe a serious slowing — and perhaps the COVID shock from Delta.

My friend David Rosenberg reasons, “Now that fiscal stimulus is shifting to fiscal withdrawal, one can expect demand growth to ultimately slow below available supply once the pandemic ends, and with that, a return to disinflation” (October 1 email promo for subscribers, “So if You Don’t Like “Transitory,” How About “Ephemeral”? Special Report: September 30, 2021, Rosenberg Research, https://www.rosenbergresearch.com). We think Rosie is on the mark.

All of those factors come together. No one of them can be directly confirmed as the primary reason for market volatility.

But there’s one other piece that hasn’t made the public radar screen. This commentary is devoted to that obscure element.

You will need 20 minutes to read about a special provision that the Federal Reserve has never used but has discussed. All this remains moot unless the Congress drives the nation to the point of default.

The problem is that the present Congress might be so dysfunctional as to trigger an actual technical default by the United States. Here’s the story.

A recent Brookings piece offers background: “How worried should we be if the debt ceiling isn’t lifted?” https://www.brookings.edu/blog/up-front/2021/09/28/how-worried-should-we-be-if-the-debt-ceiling-isnt-lifted/.

Let’s move on. We’ve received permission from Bill Nelson to share his email blast, which he titled, “Memo on FOMC Exit discussions, No Taper if Debacle, and Fed’s plans if there is a default,” copied below:

“Please find attached a memo that summarizes the FOMC’s discussions between 2009 and 2011 on exiting from extraordinarily high levels of monetary stimulus. The memo is by Ellen Meade, cc’d, a recently retired Senior Advisor from Board’s Monetary Affairs Division.  The memo provides useful insights for the exit process that will likely start with tapering in November.” (Readers can access Ellen Meade’s memo here:  https://www.cumber.com/pdf/Commentary/20130313.Exit.Memo.Ellen.E.Meade.pdf.)

Note that this memo was made public on September 27. We thank Bill Nelson. Without his permission and disclosure, market agents wouldn’t have known of its existence.

Nelson continues: “As I am sure most of you noticed, in the post FOMC press conference, Chair Powell signaled that tapering may not begin in November if there were significant market turmoil from a debt ceiling debacle. In particular, he indicated that the decision to taper will depend not only on the employment and inflation situation, but also whether “the overall situation is appropriate” and that they will ‘look at the broader environment at that time.’

“If you haven’t already, you should review the transcripts from the two intermeeting FOMC meetings that were held to discuss what the Fed could do in reaction to a federal default – in August 2011 [“Conference Call of the Federal Open Market Committee on August 1, 2011,”
https://www.federalreserve.gov/monetarypolicy/files/FOMC20110801confcall.pdf] and in October 2013 [“Conference Call of the Federal Open Market Committee on October 16, 2013,” https://www.federalreserve.gov/monetarypolicy/files/FOMC20131016confcall.pdf]. Of most interest are the briefings by Bill English, Division Director of Monetary Affairs, in 2011 starting on p. 19 and in 2013 starting on p. 15. That said, both the transcripts are worth reading in full (including remarks by Powell and Yellen). The plans included a range of options including accepting defaulted Treasuries as collateral at the discount window up through purchasing defaulted securities in the open market (at market value). I wonder if the Fed’s new Standing Repo Facility would accept defaulted securities?”

We (Kotok) were honored to be part of the group discussion Bill Nelson’s blast triggered about this subject. Another group member and good friend, former Philadelphia Federal Reserve President Charles Plosser, gave me permission to quote the comment he made when he forwarded Bill Nelson’s email blast to me. Charlie warns about moral hazard. We completely agree with his warning:

“I got this from my friend Bill Nelson. It is background information on the FOMC meeting in 2013. He was involved. I’m not sure I agree with it all, but it illustrates how the Fed thinks about such things. There is background to the FOMC transcripts earlier referred to.”

Charlie ended with the warning that we believe is alarming those skilled market agents.

"The Fed can stretch any unusual financial event to justify intervention. This is where the moral hazard argument comes in.”

Thanks to Bill Nelson, Charles Plosser, and others who have been engaged in an ongoing dialogue about Fed policy and this new and obscure procedure, we were able to gather the references and offer them to clients and readers to review.

The document, released on September 27, that describes the policy is the now-public record of a FOMC conference call that occurred on August 1, 2011, and it reflects part of the discussion the last time we had a debt-ceiling crisis, back in 2011. The paragraph which follows is excerpted from page 20. In this section Fed economist Bill English describes actions the Fed could take in the event of default:

“In our memo, we divided the possible actions that the Federal Reserve could take into four groups, and I’ll follow the same approach here. The first group included five policies that fall within the current authorization of the Desk and the authority of the Reserve Banks. For those five, we suggested that Federal Reserve operations should treat defaulted Treasury securities in the same manner as nondefaulted securities, but with defaulted securities valued at their own market prices. This basic approach seems appropriate so long as the default reflects a political impasse and not any underlying inability of the United States to meet its obligations, so that all payments on defaulted securities would presumably be made after a short delay and the securities remained very low risk.” (“Conference Call of the Federal Open Market Committee on August 1, 2011,”  https://www.federalreserve.gov/monetarypolicy/files/FOMC20110801confcall.pdf)

For our clients and readers, let me also call your attention to this paragraph from the discussion which follows on page 21 (still quoting Bill English). Serious researchers may want to read through the entire set of minutes.
 

“In the fourth group of actions, Brian and I suggested that the Committee could, if it chose, engage in either outright purchases or CUSIP swaps of defaulted Treasury securities. Such operations could be warranted if the Committee determined that there was a need to increase its support of market functioning by removing defaulted securities from the market. However, such an approach could insert the Federal Reserve into a very strained political situation and could raise questions about its independence from debt management issues faced by the Treasury.”


(“Conference Call of the Federal Open Market Committee on August 1, 2011,” https://www.federalreserve.gov/monetarypolicy/files/FOMC20110801confcall.pdf)

CUSIP swapping of defaulted Treasuries!  Outright purchase of defaulted securities!

Here’s a separate link to the 2013 meeting in which this subject was discussed: “Conference Call of the Federal Open Market Committee on October 16, 2013,” https://www.federalreserve.gov/monetarypolicy/files/FOMC20131016confcall.pdf.

Please let me call attention to this paragraph from page 5, as Linda Robertson, assistant to the Board at the Office of Board Members, prefaces her briefing on congressional activities. Again, serious researchers may want to read through the entire set of minutes. You can read this now-public Fed history and warning and insert today’s date and identify today’s Congress.
 

“Thank you, Mr. Chairman. I’ll start with the current government shutdown and debt ceiling debacle, which are nearly at an end. There are many ways to account for the tremendous losses from this episode. Jobs in the private and public sector, consumer confidence, our international standing, a possible and perhaps permanent erosion in the full faith and credit standing, critical government data, and a calling into question of our systems of governance are just a few of the many losses from this self-inflicted wound. But the even more remarkable thing about this episode is that the proposed deal does not do anything whatsoever to resolve our longer-term budget or fiscal-related questions. I’m afraid that when we look back on this episode perhaps the biggest loss is that there were absolutely no lessons learned from this crisis.”


Here’s why my opening quote was from the American Banker. On pages 12 and 13, Michael S. Gibson, Director, Division of Banking Supervision and Regulation, Board of Governors, characterizes the guidance under discussion:
 

“The guidance covers three issues. First, it makes it clear that the supervisory and regulatory treatment of Treasury securities, other securities issued or guaranteed by the U.S. government or its agencies, and U.S. GSEs, for which a payment has been missed—these will not have any change in their risk-based capital treatment. Their risk weights don’t change. They will not be adversely classified or criticized by examiners, and their treatment under other regulations, such as Regulation W, would not be affected. Second, the guidance says that potential balance sheet growth from unusually large deposit inflows or draws on existing lines of credit may result in a temporary decline in regulatory capital ratios, and that institutions that experience such a decline should contact their primary supervisor to discuss how to address the situation, and that supervisors would consider whether such an institution is still in fundamentally sound condition, even if there is a temporary drop in its regulatory capital ratio. And, third, the guidance would encourage institutions to work with their affected customers and use the flexibility that already exists to work with borrowers who may experience temporary financial stress. We have discussed with the other agencies the draft guidance, and we would be ready to issue that if and when needed.”


(“Conference Call of the Federal Open Market Committee on October 16, 2013,” https://www.federalreserve.gov/monetarypolicy/files/FOMC20131016confcall.pdf)

Dear clients, consultants, and readers, it is our opinion that markets would go into disarray if the conditions imposed on the United States and the rest of the world by the Congress of the United States were to reach such a deadlock that the debt ceiling issue is not resolved. Markets are assuming it will be resolved. That’s what they have assumed each time.

Market agents look at this and say, “This is a charade. It’s a political game, and it has nothing to do with the ability of the United States to make a payment when due.” We usually agree, with one exception.

In all prior circumstances, when the United States Congress played brinksman with the credit of the United States, market agents thought that Congress would come together and not trigger a default. The one instant for the one day when there was an actual possibility of default sent the markets into a 4% downturn; the bond market went into gyrations and cost the entire country billions in expenses. You can read the August 1, 2011, minutes of the Fed conference call, and you can see how costly this awful, shameful political behavior of the Congress is for our country and for the rest of the world.

We are now playing with fire, and members of Congress who think they can engage in some new level of brinksmanship by forcing the Fed to incur these never-before-tried procedures as a backstop to force the Treasury into a technical default are doing the worst service they can to the United States, all of its citizens, all of its businesses, and everybody in the world who works with us. And they are benefiting everybody in the world who is our adversary or enemy.

We think the recent market volatility reflects this factor as well as the other factors listed at the beginning of this commentary, and markets don’t know how to price this risk. They’ve never had to deal with it before, and the Fed itself worries about how to implement this emergency procedure. It’s never had to do it before.

We think there has been volatility in the Treasury market and a downdraft in the stock market in part because this obscure issue got on the table as one of the factors.

This is a new factor, and it is impossible to assign a probability to it; it is a political risk element that is highly uncertain and very dangerous.

The more that financial and economic commentators and professional analysts, the financial media, and others focus on this moral hazard risk and the danger that the Congress of the United States is now imposing on the country, the better the chances are that the Congress won’t be crazy enough to carry through with the destructive folly that it periodically threatens.

On Thursday, September 30, the Senate voted to fund the government into early December, but the debt ceiling fight remains unresolved. The can has been kicked only a few days and weeks further out on the calendar. (“Congress approves government funding bill hours before midnight deadline to avert shutdown,” https://www.washingtonpost.com/us-policy/2021/09/30/house-senate-shutdown-vote/)

Personally, I wish there were a way to throw them all out of Congress and start over again, but we don’t have that luxury. We do have the freedom to articulate our concern about a very dangerous moral hazard precedent.

We’re going to close this commentary with a YouTube link to a song from Hamilton. The documents that we have excerpted and linked to here are now open to the public and available for analysis; but remember, once they were private. There is a great deal to learn from them. Let’s enjoy this theatrical reference to a period of our history that preceded the Fed and the Eccles Building. Please remember that the first debt fight was about the new US assuming the debts of the states after the Revolutionary War. We’ve been in the political debt-ceiling battle ever since. With that in mind, here’s “The Room Where It Happens”: https://www.youtube.com/watch?v=WySzEXKUSZw.

 

 

David R. Kotok
Chairman of the Board & Chief Investment Officer
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