Right Debt-Ceiling Deal Could Stoke the Market
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The Fiscal Times
July 7, 2011

President Obama emerged from budget negotiations with House Speaker John Boehner and other congressional leaders Thursday saying that the talks had been “very constructive.” But while the debt-ceiling discussions in Washington may be showing some signs of movement, Wall Street is still waiting to see where that movement leads.

“The financial markets have discounted the noise coming from Washington,” says Fred Dickson, chief market strategist at D.A. Davidson & Co., and investors so far “have placed a very low probability” on a breakdown in talks that would lead to the federal government defaulting on its debts. If investors were truly worried about a deal being reached, bond yields would be significantly higher and the stock market would be more frenzied, says Michael Sheldon, the chief market strategist at RDM Financial Group.

So an eventual agreement to raise the debt ceiling and avert any threat of default could allow investors to breathe a sigh of relief and may give the stock market “a little bit” of a boost, says Dickson, but Wall Street reaction to a deal—if one is reached—would depend on the broader scope and shape of the compromise.

“The specifics are important,” says Jason Waxler, a portfolio manager with Fogel Neale in New York. “The structure of any deal will be very important to financial markets,” says Sheldon.

Obama and Boehner are reportedly discussing a deal that seeks to slash $4 trillion in spending over the next decade, including cuts to Social Security and Medicare. Boehner has reportedly also signaled a willingness to raise $1 trillion or more in new revenue by eliminating certain tax breaks. Those added revenues are an important part of the equation for Wall Street, says Waxler. “If they’re just cutting, I don’t see how that’s really bullish for the markets,” he says.

That kind of broad deal including entitlement reforms, some revenue gains, and an increase of $3 trillion to $4 trillion in the debt ceiling would likely be “very favorable” for the stock market, Jeffrey Kleintop, chief market strategist at LPL Financial, notes in a report this week. “The stock market would likely post a sizable double-digit gain over the following weeks,” Kleintop writes, and the dollar would also move up sharply, pushing commodity prices lower.

By contrast, a smaller deal –one that involves spending cuts, the elimination of some tax breaks, and more modest changes to the way Social Security benefits are calculated—might not move the markets much at all, Kleintop suggests. “The markets have largely priced in this outcome and are unlikely to make a major move in either direction if this is the result,” he says.

Some on Wall Street are also concerned that deep spending cuts, even if they might be necessary for the nation’s long-term fiscal health, could prove to be an unwelcome economic headwind. And if those cuts get enacted all at once, the impact could be particularly harsh. “If austerity measures are severe and front-end loaded then the impact on the economy over the next one to three years could be more dramatic than investors anticipate,” says Sheldon.

Just as important, where the cuts are made—and how deep they go—will help determine Wall Street winners and losers. Cuts to Medicare, for example, would be a drag on the health-care sector. But before investors know how any deal will ripple across the economy, “we’ll have to see the details,” says Sheldon.
Obama, Boehner, and other Congressional leaders will try to hammer out more of those details when they next meet on Sunday

More overage of the debt ceiling from The Fiscal Times:
What Debt Limit? Plan B is the 14th Amendment
5 Ugly Truths about the Debt Ceiling Battle
Debt Ceiling May Come Crashing Down on Treasury

Executive Editor Yuval Rosenberg oversees coverage of business, the economy, technology and Wall Street. A former web editor at WNYC, Fortune and Newsweek, he also writes on a wide range of subjects.