Investor calm could prolong debt ceiling duel

(MoneyWatch) Mixed messages from Wall Street regarding the urgency of raising the nation's debt ceiling could deepen the standoff in Washington.

Prominent bank CEOs have in recent days issued dire warnings about the potential economic impact of Congress failing to boost the government's borrowing limit. China, which combined with Japan holds $2.4 trillion in U.S. Treasuries, upped the ante Tuesday by urging the U.S. to end the stalemate. "We ask that the United States earnestly take steps to resolve in a timely way the political issues around the debt ceiling and prevent a debt default," said Vice Finance Minister Zhu Guangyao. "This is the United States' responsibility."

But while stocks have declined during the partial government shutdown, there has been nothing like the anxious sell-off that preceded the 2011 conflict in Washington over the debt ceiling. That takes some pressure off lawmakers to reach a deal on the borrowing cap by next week, experts said. The Treasury Department has said it will not have enough money in its coffers to pay the nation's bills on Oct. 17.

"Maybe we need a bit more panic in the markets," said Jim O'Sullivan, chief U.S. economist with High Frequency Economics. "Historically, Congress acts quicker when there's a sense of crisis."

A couple of factors could account for the relative calm in financial markets. First, the prevailing view among market watchers is that congressional leaders will eventually raise the borrowing limit. That is necessary to ensure that the U.S. can service the interest on U.S. Treasury bonds and make scheduled Social Security, veterans benefits and other payments.

"The idea that we would renege on any of our debts is inconceivable," O'Sullivan said.

Second, the perception among investors is that the turmoil in Washington has already damaged the economy, mostly by hurting the confidence of consumers and businesses. While that may be bad for Main Street, the ongoing dysfunction on Capitol Hill could encourage the Federal Reserve to extend the monetary policies it has in place to stimulate growth.

Until most federal agencies locked their doors starting last week, many economists and equity analysts had expected the central bank to begin scaling back its $85-billion-a-month bond purchase program, or "quantitative easing," in December. But the impasse in Washington could delay the start of such "tapering" until well into 2014, which could provide more lift to stocks and even turn the recent downdraft in equities into a buying opportunity.

Meanwhile, some observers are skeptical of claims that a debt default would immediately trigger a global financial crisis, rejecting the analogy to the 2008 collapse of investment bank Lehman Brothers.

"Lehman's impact on the market was because of the broad counterparty risk," said Scott Clemons, chief investment strategist, wealth management, at private bank Brown Brothers Harriman, alluding to the close linkages between financial firms during the crisis. "I don't see that same counterparty risk with U.S. Treasuries."

And unlike Lehman, which became insolvent after mortgage-backed securities vaporized during the housing crash, no one doubts the U.S. government's ability to pay its debts. 

Julian Knessop, chief global economist with market research firm Capital Economics, added that the impact of a short-term, "technical" default -- in which the U.S. temporarily missed a single payment -- "should be limited and far less severe than that which followed the collapse of Lehman Brothers."

If financial markets have shown no signs of panic, investors are clearly feeling jittery. The Dow Jones industrial average on Tuesday fell nearly 160 points, or 1 percent, to 14,777. Activity was more placid on the Standard & Poor's 500 and Nasdaq composite indexes, which lost 21 and 75 points, respectively.

Clemons also expressed concern that investors may be showing too much confidence that lawmakers will steer the U.S. away from a debt default. "Complacency is dangerous," he said. "It's the enemy of investors, and it makes me a little anxious that the market is being complacent in reacting to a potential default."

Investors are likely to grow more fearful with every passing day without a deal to raise the debt cap.

"The intensity of the decline we've seen in equities could increase if we approach the weekend without any obvious prospects of a compromise," said Mark Luschini, chief investment strategist with broker-dealer Janney Montgomery Scott. "If we reach Oct. 17, where the government is going to have prioritize [payments], you're doing that on borrowed time."