The Sound of Silence

The reason why so few people are agreeable in conversation is that each is thinking more about what he intends to say than what others are saying.

-Francois Duc de la Rochefoucauld

We are overwhelmed by silence!  The quarter ended with a bang, brought about largely by the silence of the Federal Reserve.  In their announcement on September 18th the FED said…well nothing really…they would simply keep purchasing bonds at the same 85 billion dollar per month rate that they have been utilizing since they initiated QE3 in September 2012.  This cleared the way for a strong late quarter rally and set the U.S. up for a strong fourth quarter as well.  Perhaps more importantly, with the withdrawal of Lawrence Summers from the “race” for Chairman of the Federal Reserve, the Bernanke FED utilized the opportunity to transition itself to the Yellen FED.  Janet Yellen is, if possible, even more dovish than Chairman Bernanke.  So the likelihood of any reduction in the rate of bond purchases throughout the remainder of 2013 is quite low.  Furthermore, with Yellen in control of the monetary spigot, it is likely that FED policy will remain accommodative for the next couple of years.  Regardless of the philosophical wisdom of such an approach, the continuation of accommodative policy is likely to buoy risky assets both in the short and intermediate term. 

Simon and Garfunkel, in their epic work created in February 1964, penned the following lyrics: “People talking without speaking, people hearing without listening, people writing…laws, oh sorry, we meant… songs that voices never share and no one dared, disturb the sound of silence.”  Over the last couple of weeks, the market exhibited a growing level of concern over the government shutdown and debt ceiling debate.  The recent short-term solution cobbled together by Congress provides nothing more than a temporary moratorium on that instability; however, we believe the market will likely be content with the status quo, and therefore, the deal cobbled together and agreed to by both houses of Congress and approved by the President will probably result in a relief rally.  As we noted above, the real problem is the lack of reasonable communication over the issues involved and the unwillingness of our elected officials to deal with these issues.  The current deal, according to Reuters, extends Federal spending at current levels through January 15th and U.S. borrowing authority through February 7th.  In a nod to the intractability of our current situation, the following was also noted by Reuters: “Under a device that allows lawmakers to assert they did not vote for raising the ceiling, President Barack Obama would notify Congress that he is raising the U.S. debt limit, giving lawmakers the opportunity to override him with a two-thirds vote of each chamber. But that is unlikely to happen.” (emphasis ours)  We do not believe the political environment is likely to change anytime soon, but the market seems to have come to grips with the situation, at least temporarily.  

We should note that there have been seven government shutdowns in the last 40 years, and their impact on the market has been negative but relatively minor.  The recent events of 2011 have led to greater visibility of the debt limit and its impact on markets.   Prior to 2011, the debt limit discussion was rarely an issue…perhaps because it was so common and easily resolved the market generally ignored the event. 

A broad based limitation on U.S. debt issuance goes back to 1917 and the original issuance of Liberty bonds to help fund U.S. expenditures during World War I.  Prior to World War I Congress granted funding/debt issuance approval on a case by case basis and continued to do so in large part until the 1930s when greater flexibility was granted at the request of Treasury Secretary Henry Morgenthau.  Throughout the next two decades, the debt limit was adjusted a number of times to facilitate the financing of World War II and to adjust for the decline in indebtedness following the era surrounding the war.

The modern period commenced in the 1960s, and since 1962 Congress has altered the debt limit in some fashion 77 times.  Over the last decade changes to the debt limit have occurred in nearly every year, and many of those changes have been pushed to the eleventh hour as negotiators sought a compromise.  However, there was little market response until the 2011 debate when U.S. debt was downgraded for the first time in history.  The contentious nature of that debate seems to have raised the profile of the debt ceiling discussion and its potential market impact.  Consequently, the unwillingness of politicians to engage in a reasonable debate has impacted markets in recent days and raised the specter of additional debt downgrades.  To some extent one might consider the debt ceiling to play the role of the canary in the coal mine.  To many it signals the erosion of U.S. fiscal responsibility; however, in reality, as outlined above it is primarily a cash flow management issue.  The real problem is the bills that Congress approves that require financing in the first place.  Titular legislation like Social Security, Medicaid, Medicare, and the Affordable Healthcare Act require funding and are hard to undo after being voted into law.  Unfortunately, the debt ceiling simply acts as a flashpoint for partisan discussion over how the United States spends its funds.  In our view, although nothing has been solved, the temporary impasse has been mitigated, and it is likely that the market will rally during the remainder of the fourth quarter.  Unfortunately, we are likely to be discussing these same issues again in the early part of 2014 with corresponding market volatility.