Dow Jumps More Than 200 Points On Debt Deal

3:31 PM, Oct 16, 2013   |    comments
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Adam Shell, USA TODAY

NEW YORK - The big bet on Wall Street that has fueled Wednesday's stock market rally proved to be correct as top Senate leaders say they have struck a bipartisan deal to reopen the government and extend the nation's debt ceiling.

The comments by the top ranking senators from both parties, Democrat Harry Reid and Republican Mitch McConnell, likely mark the end of a debt impasse that has shut down the government for 16 days. It will also remove the threat of the nation defaulting on its debts for the first time in history and reduce the level of market uncertainty.

The deal, of course, needs to be ratified by votes in both houses of Congress and signed into law by President Obama, perhaps as early as today.

The deal calls for the government to reopen and be funded through Jan. 15 and the debt ceiling to be extended through Feb. 7.

The Dow Jones industrial average jumped 206 points, or 1.4%, to 15,374, according to preliminary calculations. The Standard & Poor's 500 index gained 24 points, or 1.4%, to 1,722 and the Nasdaq composite index surged 45 points, or 1.2%, to 3,839, a fresh 13-year high.

If the deal closes, investors will breathe a big sigh of relief and refocus their attention on more mundane matters such as corporate earnings and the economy, says Nicholas Sargen, chief investment officer at Fort Washington Investment Advisors.

"If a default is ruled out (by a "Yea vote), the market will say it's time to refocus on business fundamentals," says Sargen, adding that he doesn't think the nearly three-week budget fight will cause "lasting damage to the economy or the nation's financial reputation."

Stocks have held up fairly well during the government shutdown, a sign that Wall Street was correctly betting that Washington would reach an agreement. The market began to price in a positive resolution last week, fueling a big market rally that saw the Dow climb more than 500 points.

Whether stock prices will skyrocket even more is in question, given the market's sharp rise in anticipation of the crisis ending without financial calamity, says Rod Smyth, chief investment strategist at Riverfront Investment Group.

"The market never panicked and never priced in the bad scenario, so it's unlikely to storm away to the upside if we get a resolution," says Smyth.

While stocks shot up, investor fear took a big dive. A closely watched Wall Street fear gauge fell by 20% on news that a deal had been worked out.

The key reason investors thought a deal would get done: the fallout of a U.S. default would be so unpredictable and potentially damaging to the financial system that few people on Wall Street believed Congress would let such a self-inflicted wound occur.

"We have to assume that it is in no one's interest for the government to default," says Rob McIver, co-portfolio manager at Jensen Quality Growth Fund.

The short-end of the U.S. bond market, which showed signs of distress in early trading also reacted bullishly to news of an agreement in Washington. The yield on the Treasury bill that comes due on Oct. 31, dubbed "The Halloween Bill," jumped as high as 0.62% in trading today, despite trading in a normal range of 0.05% to 0.10% for most of the year before moving higher and higher this month, according to a Bloomberg chart supplied by UBS. However, the yield plunged to 0.26% after the Senate leaders announced the deal and fears of default plummeted.

This type of short-term bond is typically referred to as a risk-free asset, but investors had been selling these bills because they are the most likely government security to be hit by a U.S. default, according to Boris Rjavinski, an interest rate strategist at UBS.

Longer-term government bond prices also rose on the news. The yield on the 10-year Treasury note, which climbed as high as 2.75% today, has dipped to 2.68%.

In overseas trading, the Nikkei 225 Stock Index closed up 0.18% to 14,467.14, however Hong Kong's Hang Seng fell 0.46% to 23,228.33.

Similarly, key European stock indexes closed mix. Britain's FTSE 100 index rose 0.30% to 6,571.59. Germany's DAX 30 index gained 0.50% to 8846 while France's CAC 40 index was down 0.30% to 4,243.72.

The clock was ticking closer to the key Oct. 17 deadline -- that's tomorrow. If the deadline passed without a deal to extend the debt ceiling, the U.S. would not have been able to borrow any more money and would have run short on cash in coming days and weeks to pay its bills.

The biggest risk is if sometime after Oct. 17, the U.S. misses interest or principal payments on government debt it has already issued. Such a default could undermine the world's confidence in a financial asset that's long been viewed as the safest investment on Earth.

Due to political brinkmanship, after last night's market close Fitch Ratings cited the potential hit to confidence due to a potential default as a reason it placed the USA's AAA rating on "rating watch negative."

Standard & Poor's, of course, downgraded U.S.debt to AA+ in the summer of 2011 after the last debt-ceiling fight. And John Chambers, chairman of S&P's sovereign debt committee told "CBS This Morning" today that if the U.S. does not pay its bondholders on time and defaults, the reaction in financial markets would "probably be an event that would be much worse than (the bankruptcy) of Lehman Brothers" back in the fall of 2008. Still, in a later interview with CNBC he said S&P does not expect the U.S. to miss a debt payment.

Still a Q&A research note put out yesterday by credit rating agency Moody's Investors Services that downplayed the odds of a credit rating downgrade for the U.S. has provided a sense of balance to the ratings downgrade debate.

Memories of the bad market reaction to the last debt-ceiling fight in Congress back in 2011 has some investors worried. As the talks dragged on in July of 2011 before ending in a last-minute deal to avoid default, the Dow suffered an eight-day losing streak in late July and early August. The blue-chip gauge then plunged 635 points, or 5.6%, on Aug. 8, 2011, the first day of trading after the S&P credit downgrade.

"The problem with the U.S. not paying investors on time is that it can destroy the very special status of Treasuries as a super-safe, liquid investment," says Rjavinski. "Treasuries are like an invisible glue that binds all of the world's financial markets. We can have a pretty bad chain reaction if there's a default."

The stock market has navigated Washington gridlock nicely so far. Despite a 133-point drop for the Dow Jones industrials on Tuesday after Congress failed to sign a deal, the Dow was still up 0.25% during the 15-day government shutdown. If the deadline passes without a deal, however, stocks would likely suffer a "strong negative reaction," says McIver. If a deal gets done, the market will refocus its attention on corporate earnings and economic growth, he adds.

But there have been more concrete signs of worry in the U.S. government bond market, especially one-month Treasury bills that will come due between Oct. 17 and early November, when the nation is expected to run short of cash.

Many banks and big investors have been selling these short-term instruments that could be hit by a potential default, says Bill Hornbarger, chief investment strategist at Moneta Group.

"Everyone is selling stuff that matures in October," he says.

A Treasury bill that matures on Oct. 24, seven days after the nation's ability to borrow ends, has seen its yield jump from roughly 0% in mid-September to more than 0.40% in recent days, according to a Bloomberg chart supplied by Rjavinski.

The issue isn't that investors don't think they will get paid back eventually, says Rjavinski; it is that they won't get paid on time.

"It's telling us investors are getting nervous," says Rjavinski.

Intel was down 0.99% to 23.18 in premarket trading despite topping Wall Street's estimates Tuesday by reporting a 49% increase in quarterly profit of $3 billion, or 58 cents a share.

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