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DeAWM expects agreement before US debt ceiling is reached

Asoka Wöhrmann, Co-CIO at DeAWM, on the US-Government-shutdown and debt-ceiling…

The budget and debt-ceiling battle in the United States has the world holding its breath. The fronts between the Republicans and the Democrats seem to have hardened. At the same time, a ceasefire must be reached by 17 October. This is the date the United States is expected to hit the USD16.7 trillion debt ceiling.

After that point, the United States will not be able to pay its bills. Deutsche Asset & Wealth Management (DeAWM) has prepared three scenarios outlining the further development of the crisis and its implications – a quick solution, a drawn-out compromise in which the United States avoids default, and the worst-case scenario of default should the parties not reach an agreement.

The three scenarios as follows:

Baseline scenario – We are confident the opposing parties in the United States will reach an agreement. In our baseline scenario, we believe the shutdown will end soon and the debt ceiling will be raised in order to avoid technical default. In general, the impact on financial markets and the US economy will be limited. The Fed could begin winding back quantitative easing, ie, tapering its bond purchases, in December.

Risk scenario No1 – If the shutdown does not end in time for the debt ceiling to be raised, technical default could still be avoided – for instance, if the US Treasury were to prioritise payments of its obligations or take similar steps. In this scenario, we see political haggling continuing into November – at which time a solution would be found. The shutdown would have a significant negative impact on the economy during the fourth quarter, to the tune of around 1 percent of GDP for the entire year. The Fed would then begin winding back quantitative easing, ie, tapering its bond purchases, during the first quarter of 2014 at the earliest.

Risk scenario No2 – In the worst-case scenario, the United States would default on its debt in November, unleashing a disastrous effect on the economy. This scenario is the least likely to become reality. Technical default would prompt extreme market volatility, with strong turbulence occurring primarily in the US bond and repo markets. US bonds would rally until default occurred, followed by a sell-off as foreign central banks shed their Treasury bonds. Risk aversion would rise worldwide, and a global sell-off of risk-graded asset classes, such as stocks, would ensue. The economic damage would be significant and act as a drag on growth for some time. The resulting weakened confidence would create problems for all asset classes with higher risk levels. The economy would experience sluggish growth for some time. As a result, the likelihood of the Fed winding back quantitative easing, ie, tapering its bond purchases, in the foreseeable future is negligible.

 

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