Why the Debt Ceiling Is the Wild Card in the Fiscal-Cliff Drama

I hope you’ve had a wonderful new year and that your resolutions stick for a long time to come. In the meantime, it’s time to jump right back into the business of making money. And it looks like we’re about to enter some very familiar territory.

In my Uncommon Wisdom Daily column on Nov. 28, I said:

“The Chicago Board Options Exchange’s Volatility Index (VIX) has come to reflect the sentiment of traders. Periods of high and rising volatility have corresponded with periods of risk aversion; and vice-versa with periods of risk appetite.

“I received a piece of technical analysis on the VIX a couple weeks ago. It highlights an indicator that might help predict market direction at key VIX inflection points. … I see a set-up similar to earlier this year.

“At that time, risk appetite recovered and sent markets rallying. Might we see a repeat?”

I also included a chart. Here it is, updated with current price action:

For the most part, that call for a repeat head-fake was on point. But now volatility is jumping, and a cross of key moving averages appears imminent.

Such a cross would suggest volatility has the potential to rise further and remain high.

Is there an obvious catalyst for this rise in volatility? I think so, and that it’s the “same auld lang syne” we’re used to hearing.

Debt Ceiling: The Wild Card in the Fiscal-Cliff Drama

Around August 2011, the debate raged about extending the U.S. debt ceiling.

Analysts were concerned. What would it mean if lawmakers didn’t agree? What would it mean if the limit was not raised once government’s spending pushed debt (further) through the roof?

It seemed like the immediate consequence could be a ratings downgrade. Never in its history had the U.S. lost its “pristine” top-notch credit rating.

Laughable as it may seem now, it was a legitimate concern for investors. No one knew how the herd would react to such news.

The debt ceiling was eventually raised. It came with loose commitments from our illustrious Congress to get serious next time our out-of-control debt starts bumping its head again.

Again, it’s laughable. But it got the U.S. out of the woods, so to speak.

Or did it?

Déjà Vu a Big Risk Right Now

Three days after the debt ceiling agreement, Standard & Poor’s downgraded the U.S. credit rating.

Stock markets sold off sharply. They bottomed three days after the downgrade. In a mere 13 days after Congress reached an agreement, the President signed a budget act and S&P downgraded the country. In those same 13 days, the S&P 500 lost as much as 20%.

Ouch.

But the good news: Stocks bottomed at that low point and rallied 37% over the next 12 months.

Using the Thomson Reuters/Jefferies CRB Index as a yardstick, commodities slowly and steadily leaked away about 20% of their value. But the index has yet to retake the levels from which it dropped when the U.S. was downgraded.

A look at the iShares MSCI Emerging Market Index Fund (EEM) reveals the worst of both worlds. Like U.S. stock markets, EEM dropped 25% quickly after the U.S. downgrade. And like commodities, EEM has not yet retaken the level from which it plunged.

I bring this up because there is a very real risk of it all happening again.

Cautiously Bullish, With an Emphasis on ‘Caution’

Currently, I’d classify my market outlook as cautiously bullish. I think the market is, to a large degree, desensitized to policymaking now.

Even if we do “go over” the fiscal cliff, President Obama will certainly ride to the rescue with newly proposed — read: retroactive — tax relief for the middle class.

The empty, never-ending debate over taxes and spending is disgusting to me. But the real issue right here, right now, is the debt ceiling. And failure to raise it — or raise it enough — would quickly sap the Treasury’s cash for paying bills and risk default.

This ongoing cycle of useless budget resolutions is what S&P feared when it downgraded the U.S. last year. And it might be the most important issue as we traverse the markets early this month.

Are we on course for a major market meltdown until the fear effectively subsides with an extension of the debt ceiling and an agreement on spending and tax-cut extensions?

If the VIX moving average crossover is a reliable indicator, it appears the market could get quite dicey in the weeks ahead.

Happy New Year! And keep working on those resolutions.

Best,

JR

“JR” specializes in trading commodities, currencies and options. He has spent nearly 10 years analyzing financial markets and writing about global economics. JR honed his trading techniques and global-macro worldview alongside his father, Jack Crooks, at Black Swan Capital. JR also…