A Deficit of Progress

That the United States should find itself in this position is not exactly unexpected. The US Congress has been loathe these last 10 years to pay for the foreign adventures, tax cuts and new entitlements that they have proven all too willing to fund. The thing is the chickens have not yet come home to roost. Instead, the Republican party and perhaps more specifically the TEA party wing of the Republican party seems bound and determined to bring the roost to the unsuspecting chickens. The roost in this strange avian metaphor is the limit on the US national debt and the chickens are the unfortunate people to whom the US owes money. Yesterday, in the latest bureaucratic twist in this absurd tale of self-inflicted economic destruction, Republican members of Congress refused to back a bill put forth by Speaker Boehner designed to little else than make the people voting for it look good to their constituents come 2012. Basically, this was Boehner's attempt to ensure that he would have something to placate his base with when it came time for the actual compromise still to be determined. In the crazy world that is current US politics even stunt bills can die on arrival.

There is an increasing likelihood that the US will fail to raise its debt ceiling. The shortening timeline and lack of any sort of progress make it more and more likely that nothing will get done. The real question is how will the markets react to a failure to raise the debt ceiling and therefore a de facto default on US debt. Let's be clear bond holders will get paid, at least in the short term. The US Treasury will turn off the lights at the White House before they fail to pay off their bonds. However, the market will view a failure to raise the debt ceiling as a default and will look to move its money away from the contaminated American market. The question will be which market comes under attack first? There are four options for the market to vent its spleen:

1. Ditch US Stocks: This option is the one that will immediately translate to the American people and perhaps even their elected officials in Washington. A 500 to 1000 point drop in the Dow Jones Industrial Average may be enough to shock the Congress into action. This actually might be the best case scenario as faith in stocks is easily restored and there are mechanisms to easily halt trade.
2. Sell US Bonds in the Secondary Market: This is also a fairly painless option. The price of US bonds in the secondary market has very little impact on the US treasury directly. If people are paying 90 or 85 cents on the dollar for 30 year US bonds issued 10 years ago, the market can handle that. The problem is that directly impacts the next option:
3. Refuse to buy new US bonds: Okay, technically with the debt ceiling capped the US can't issue new debt. However, they do perennially turn over old debt (I believe the next major batch is scheduled to be in the middle of August). If the debt ceiling is not raised, the market will undoubtedly demand a premium well above the historically low interest rates available today. A run on US bonds in the secondary market would probably trigger massive interest rate hikes to try to stem the tide and make the new bonds marketable.
4. A Run on the US Dollar: Investors may decide that the easiest way to get away from the risk inherent in the US market is to sell greenbacks and fast. A run on the green back would cause massive inflation and also force the Fed to raise interest rates to try to beat back the barbarians at the gates. A run on the US dollar is the worst case scenario as it would cripple the US market with inflation and cause untold disaster in the rest of the world.
   

The reason I ask which option the market will choose is because it may prove very difficult to do all four at once. Put simply, if you want to sell US stocks and bonds and at the same time sell US currency you need something to get back. While money will flow into all sorts of currencies and markets - Canadian Dollars, Japanese Yen, even Euros - there's no real precedent for the market trying to dump its reserve currency. This is particularly true because a large number of the major sellers are in the United States. The worst impact of this political inaction may not be felt immediately simply because the markets may struggle to punish the US fast enough.