By Erik Wasson - 06/01/11 10:00 AM EDT
Wall Street so far has shrugged off Washington’s fight over raising the debt ceiling, but experts warn patience will wane and nerves will fray after the Fourth of July holiday.
Lawmakers still have two months to reach a deal after Tuesday’s failed House vote to approve a “clean” $2.4 trillion hike in the debt ceiling that was not paired with spending cuts.
The top bond executive for BlackRock, the world’s largest asset-management firm, said there was once 100 percent certainty that a debt-ceiling compromise could be reached by Aug. 2. Now, he said, the odds are judged to be 80 percent.
Bond markets remain focused on the end of “quantitative easing II,” or QE2, the name given to the Federal Reserve’s buying of Treasuries to stimulate the economy, said Rick Rieder, BlackRock’s chief investment officer of fundamental fixed income.
“Everybody has an eye on QE2, everyone has an eye on growth in China, everybody is focused on commodity prices and now, increasingly so, people are focused on the debt ceiling, whereas I would have said a month ago nobody was focused on it,” Rieder said.
Republican lawmakers have been careful to have talks with Wall Street executives to alert them to the politics of Tuesday’s vote, which was scheduled after the markets were closed to prevent a negative reaction.
Lawmakers in both parties still remember the negative market reaction to the failed House vote to approve the Troubled Asset Relief Program (TARP) in 2008.
Wall Street sources said that reassuring calls from House Republicans leaders last week helped ensure that Tuesday’s vote would not be a surprise, and predicted markets would not plunge on Wednesday.
“I think that message has filtered down from executive offices to the trading floors that there is going to be some political drama, that these are political strategies,” said Brian Gardner of Keefe, Bruyette and Woods. “This is not the real vote.”
At the same time, the likelihood that Wall Street will react negatively if progress is not made in the debt negotiations increases as the calendar moves closer to Aug. 2.
“Eventually this will start to hit, after the Fourth of July,” said Andrew Busch of BMO Capital Markets. “If you are going to get a TARP-like situation, it is going to be around Aug. 2.”
Rieder said his firm is closely monitoring statements for signs that lawmakers will not be able to reach a compromise.
“I think there is going to be more focus as you get past July 4, but I don’t buy you can turn the switch on and off,” Rieder added. “Every signal we get that the gap is wide, or wider than people think, then I think people are not going to wait until July 4 to think about it.”
Wall Street has plenty to digest about the economy aside from the debt-ceiling talks.
Concerns about the economic recovery have increased amid slower-than-expected economic growth. On Tuesday, Standard & Poor’s and Case-Shiller released a housing index that found home prices falling 4.2 percent in the first quarter of 2011. The drop in prices represented a new low since the housing bubble burst and sparked worries of a double dip in housing prices.
The Fed’s quantitative easing is thought to be helping the economy to some degree. Once that program concludes at the end of June, there will be worries on Wall Street about how the economy moves forward. No one expects a quantitative easing III.
Questions also surround the deal the White House and congressional Republicans will reach to raise the debt ceiling.
Rieder said that markets would react positively to spending cuts demanded by Republicans because they are hungry for the U.S. to get on the right fiscal path. This would especially be the case if spending with little or no growth multiplier effects were cut.
Tax increases, he argued, would cause a negative reaction since consumption could be hurt.
Gardner also said tax increases would be viewed “very, very negative,” but that spending cuts could also shock markets.
“Collectively the markets are focused on the growth story, which is kind of lacking,” he said. “I don’t think that deep, immediate cuts would go over well.”
It’s also possible that Congress and the White House will agree to a short-term debt ceiling increase around Aug. 2 that allowed negotiators more time to strike a deal.
Kevin Giddis, president of Morgan Keegan’s fixed income capital markets division, believes markets would be “fine” with such an outcome.
“The question is: Is the U.S. government willing to let itself default?” Giddis said. “The reality is that the bond market is not in the camp yet that this could happen.”