Investors concerned about future amid debt ceiling drama

As Washington policymakers face a looming deadline to avoid breaching the federal debt ceiling on Nov. 3, investors are calmer than they were during a similar scenario in 2013 but more concerned about the country's long-term fiscal health.

One outcome in the debt ceiling drama could be additional contributions for participants in the Federal Employee Retirement System and a premium increase to the Pension Benefit Guaranty Corp.

In 2013, political brinksmanship over defunding the Affordable Care Act resulted in a U.S. government shutdown for 16 days that sent institutional investors scrambling. This time, negotiators on Capitol Hill faced the Oct. 1 start of a new fiscal year by passing a short-term spending measure extending the practical budget deadline to Dec. 11.

That put the debt ceiling at center stage, with the Treasury Department estimating that the U.S. will hit its borrowing limit on Nov. 3.

“At this point, market participants seem relatively sanguine, having lived through several episodes of debt ceiling drama and ostensibly ignoring the noise from Washington for now,” said Libby Cantrill, New York-based executive vice president of Pacific Investment Management Co. “But as we get closer to the deadline without more clarity about a path forward, we could see more market impact in the same way we did in 2011 and 2013.”

No one wants a repeat of 2011, when a delayed agreement to raise the debt limit led to an embarrassing first — a downgrade of America's credit rating. Treasury officials say they have taken “extraordinary measures” to avoid defaulting in November, aiming to protect the markets and the economy overall.

Christopher Probyn, chief economist for State Street Global Advisors, Boston, thinks the chances of an outright government default are remote. “We've been here before and we know how this plays out. It leaves us with uncertainty, but take a look at how calm the markets are. We assume that these two problems will ultimately go down to the wire,” he said.

“Most likely, we will see a protracted, volatile fight that is not resolved until the eleventh hour. Worse, we see a scenario where we go past the stated ... deadline, in which the consequences for the market and economy would be uncertain,” said Ms. Cantrill.

Simply raising the debt ceiling is not a good long-term solution, budget experts warn. According to the Congressional Budget Office, U.S. debt will be 73% of GDP in 2018, 77% by 2025 and more than 100% by 2040.

The Committee for a Responsible Federal Budget, a bipartisan non-profit group of former high level federal budget officials from the CBO, the Federal Reserve and congressional budget committees, warned that while annual federal deficits have dropped dramatically in recent years, they fell from record-high levels and the country's debt-to-GDP ratio has not improved.

“Washington's myopic focus on short-term deficits (is) leaving substantial imbalances in place over the long term,” a recent CRFB briefing paper argued. With a fiscal 2015 budget deficit of $435 billion, “the country remains on an unsustainable fiscal path.”

But reaching a 2016 budget compromise is even more complicated because neither the budget proposed by President Barack Obama nor by Congress deal with spending caps that were temporarily lifted in the 2013 budget deal. Those caps, which went into effect Oct. 1, would limit regular discretionary federalspending to $1.017 trillion in fiscal 2016, in part to spur Congress to deal with tax and entitlement reform.

Removing those caps would require a finding an additional $110 billion in federal revenueover two years. The Committee for a Responsible Federal Budget's “sequester offset plan” calls for a 1.3% pension contribution hike for all current federal workers in FERS, an effective pay cut that would save $20 billion over 10 years. Another $10 billion could come from further increases in PBGC premiums to ensure the solvency of the multiemployer program.

Those two ideas build on changes already approved in a 2013 budget deal brokered by Rep. Paul Ryan, R-Wis., and Sen. Patty Murray, D-Wash., so “we all need to be vigilant,” said one pension lobbyist who declined to be identified.

That vigilance will also be needed as congressional budget negotiators deal with the Highway Trust Fund, which runs out of money Oct. 29. As pension plan sponsors know from previous highway funding battles, past solutions have been both welcome, in the form of pension funding relief, and unwelcome, with PBGC premium increases.

An added wrinkle in the budget and debt ceiling debates is the House race to replace retiring House Speaker John Boehner, R-Ohio, with more conservative members threatening to hold up budget talks for other reasons. On the flip side, Republicans and Democrats would rather work out a two-year budget deal in 2015 to avoid having it overlap with the presidential election in 2016.

“The most recent development in the speaker's race plus the compressed timeframe to come to a resolution increases the chances of a policy mistake around the debt ceiling,” said Ms. Cantrill of PIMCO.

A Government Accountability Office study of the 2013 debt limit impasse found that investors took “the unprecedented action of systematically avoiding” Treasury securities that matured around the time that the government ran out of options. That led to a dramatic increase in rates and less liquidity in the secondary market which, because Treasury securities are widely used collateral for financial transactions, also affected other markets such as short-term financing. Market participants told GAO that with new market practices following the financial crisis and contingency plans put in place after the 2013 debt limit drama, “market reaction to future impasses could be more severe.”

If political paralysis leads to another government shutdown, “you would crunch the economy,” said Mr. Probyn of SSgA. According to Standard & Poor's Corp., the last government shutdown cost the U.S. economy about $24 billion. There could also be a ripple effect if a sluggish economy throws off the Federal Reserve's plans to raise interest rates.

“If the government were to close down for a protracted period of time, this would be a serious jolt to the system,” said Mr. Probyn. “The last time we shut the government down, it didn't work well.” n