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Foroohar: The Gridlock Economy Blues

5 minute read
Rana Foroohar

The crisis in Washington has kept us all on tenterhooks–watching for signs of a deal on federal spending and the debt ceiling amid ever more dire prognostications. We’ve now heard plenty about the consequences, perceived or real, of the U.S.’s defaulting on its debt: a plummeting S&P 500 index, a Chinese sell-off of U.S. T-bills and even a new global recession. All those things are possible. But ultimately, resolving the debt ceiling is unavoidable; the only issue is how much pain and loss we incur along the way. A more interesting–and answerable–question is what Washington’s on-and-off gridlock tells us about the economic milieu we’re already in. Here are three key market trends under way regardless of any D.C. deals.

Interest rates will rise. After all, they can’t go down any further.

In fact, rates on short-term T-bills already spiked amid the uncertainty over the U.S.’s ability to pay its obligations. The question is when and how we’ll see a longer-term rate increase. The best-case scenario has the Federal Reserve able to slowly but surely end its $85-billion-a-month asset-buying program, “taper” back on the money dump and gradually raise rates over the next year or two. Getting the timing of that right will be the key challenge for incoming Fed Chair Janet Yellen, whose confirmation will likely go through. Already, there are worries that low rates are causing market bubbles, which are always a risk when you have an easy-money environment for years on end. (Think Iceland, Argentina and subprime debt.)

But gridlock has made smart and timely tapering more complicated. Since Congress has been unwilling to boost the economy, the Fed has been forced into the role of stimulator of last resort. Part of the Fed’s mandate involves keeping unemployment low, which requires higher growth than what we currently have. It’s very likely that the shutdown will shave half a percentage point of growth from our already weak economy, meaning we may not expand by even 2% this year.

Political uncertainty creates a scenario in which interest rates can rise suddenly and unpredictably, as we’ve already seen in the bond markets in recent weeks. Market anxieties are evident in the recent boom in U.S. sovereign credit-default swaps. In snapping up swaps, investors are effectively purchasing insurance against the U.S.’s defaulting on its debts. Even if short-term rates and risk perceptions go back down, with so much Fed-generated money floating around in the market, “interest rates must eventually rise,” said hedge funder Ray Dalio, founder of Bridgewater Associates, at a recent presentation at the Japan Society in New York City. “That means that the cost of debt will rise too.”

As anyone who’s been trying to get a mortgage lately knows, that ship has already begun to sail. As rates go up, the price of everything from homes to cars to consumer goods rises too. Returns on investments of all sorts will fall, since higher interest payments erode profit margins. “The future return on nearly all asset classes is going down,” says Dalio. That’s what some investors call the New Normal.

Stocks could displace bonds as the safety asset of choice.

In the New Normal of lower returns and higher volatility, investors are looking to beat inflation by a point or two without taking on too much risk. Some blue-chip companies now look less risky than the countries in which they are headquartered. After all, what would you rather be invested in over the long haul–globally diversified stocks of cash-rich companies that are hedged across many nations and pay a predictable 3% dividend, or the relatively low-interest-paying sovereign debt of a country with a totally dysfunctional political system? (I’m looking at you, Washington! And you too, Europe!) As I’ve been saying for some time, it’s now a legitimate investment question. The debt-ceiling face-off has only brought the trend into starker relief. In recent days we’ve seen the rate on one-month T-bills exceed that on interbank loans–which means that the markets believed that companies’ ability to pay each other back was a safer bet than the trust and faith of the U.S. government.

Both the economy and politics will become more volatile.

Over the past few years, the U.S. has sadly been following a story line more typical of emerging-market nations. Politicians play chicken with the country’s credit, borrowing rates eventually go up, growth goes down, and politics becomes more polarized and extreme as a result. It’s a vicious cycle, and it’s happening as we speak. Given Washington’s willingness to take America to the brink over and over, it’s difficult to imagine how any deal can break that cycle. This is the real New Normal, and we will all pay the price.

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