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JP Morgan Sends Warning Letter to Congress & Investors

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On April 19, JP Morgan’s Fixed Income Strategy Group issued a letter of warning (pdf) regarding the negative consequences of Congress’ failure to immediately lift the debt ceiling. Here’s the important part:

Our analysis suggests that any delay in making a coupon or principal payment by the Treasury—even for a very short period of time—would almost certainly have large systemic effects with long-term adverse consequences for Treasury finances and the US economy. These effects would be transmitted through three primary channels: US money funds, the Treasury repo market, and the foreign investor community, which holds nearly half of all Treasury securities. Our main conclusions are as follows:
• A technical default raises the risk of a flight to liquidity out of government money funds, potentially triggering an increase in redemptions similar to that seen in 2008
• Repo markets will be severely disrupted as haircuts are raised and could result in a significant deleveraging event
• Even if the technical default is cured immediately, foreign demand for Treasuries could be permanently impaired. As a case in point, we note that even without any kind of default, Fannie Mae and Freddie Mac’s move into conservatorship has led to permanently lower foreign sponsorship of GSE debt.

We explore these channels in detail in the discussion below. Finally, we emphasize that even if the debt ceiling is ultimately raised before a technical default occurs, the delay in raising the debt ceiling is likely to negatively impact markets, as investors undertake risk-management actions in preparation for a potential Treasury default. Delay could also reaffirm the notion that the political compromise necessary to forge longer-term fiscal solutions is lacking, something that S&P noted in its decision to move its US ratings outlook to negative on Monday.

Further on in the letter, JP Morgan states:

In addition, the equity market would likely sell off sharply in response to a technical default, as it did on the day that Congress initially failed to pass TARP in September 2008. On that day, the S&P 500 fell 9%; using this as a rough guide, we estimate that a decline of a similar magnitude on a sustained basis in the aftermath of a default would take an additional 0.5% off of GDP growth due to lower consumption. Thus, the quantifiable effects of a default alone would likely take about 1% off of GDP growth, and the ultimate damage could be far greater.

Is it worth the risk of throwing the country into another deeper recession when the economy is already fragile, just to keep the debt ceiling – not spending – from increasing? Remember raising the debt ceiling does not automatically equate to increased spending. Just because your credit card company raises your credit limit doesn’t mean you run out and buy a whole bunch of stuff.

But not raising the debt ceiling will have an immediate and harsh impact on jobs and the economy as a whole as well as providing further impetus for the BRICS nations to push for removal of the dollar as the world’s reserve currency.

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Written by Valerie Curl

April 23, 2011 at 9:05 AM

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