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For Wall Street, Budget Battle is Just a Sideshow

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Take your pick: Stock and bond markets rallied sharply on Tuesday in part because 1) Wall Street believes Congress and the White House will agree on a balanced-budget plan this fall, or because 2) Wall Street expects a bitter budget impasse resulting in the total shutdown of the federal government.

With summer over and the markets’ focus turning to the looming budget fight--and the potential fiscal “train wreck” if congressional Republicans refuse to raise the federal debt ceiling, as threatened--some investors might argue that this is a win-win situation for markets.

Either Wall Street finally gets a bona fide plan to balance the federal budget by a set date, or Washington simply closes up shop. The thought of no federal government at all (and therefore no federal spending) naturally thrills every hard-core conservative investor.

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The federal debt ceiling now is $4.9 trillion, while total federal debt outstanding is $4.88 trillion. Unless Congress raises the ceiling, the Treasury soon won’t be able to issue new bonds to pay off older ones and fund government operations. Stephen Bell, Washington analyst for Salomon Bros., estimates that the current ceiling will be reached by mid- to late-October.

All year, some House Republicans have been gleefully awaiting autumn for the chance to finally hold President Clinton’s feet to the fire on the balanced-budget issue. Not only can the Republicans use the debt ceiling for leverage, but Congress also must pass by Sept. 30 an appropriations bill to fund the federal budget for the new fiscal year beginning Oct. 1.

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So the budget battles to be joined in coming weeks will be about both short-term and long-term spending plans. A wide gulf separates Clinton and the Republicans on both fronts. Hence, this story will quickly begin to dominate the headlines and TV sound bites.

And how will Wall Street react? As noted, Tuesday’s rallies in stocks and bonds suggest some investors might cynically be rooting to mothball Washington. But William Griggs, a principal at economic-consulting firm Griggs & Santow in New York, says it’s more likely that most big investors believe that the government is already on the path to a balanced budget--and that whatever political fireworks occur this fall will merely be for show.

“What is unique today is that Republicans and Democrats both see a need to balance the budget,” Griggs says. Congress and Clinton both have plans to that effect. The fight is over the details.

For American investors, quite accustomed to hardball partisan politics, the threat of a government shutdown that could also lead to a Treasury bond default i unlikely to suddenly spur a selloff in bonds this fall, Griggs and others argue. After all, the debt-ceiling game has been played before, in the 1980s.

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Some money managers worry about foreign investors’ reaction, however. “Foreigners are not going to be comfortable with this,” warns David Rosenberg, bond-fund manager at Oppenheimer Management in New York.

Nonetheless, most bond pros believe that the most important determinant of the trend in U.S. interest rates in the near-term will be the economic outlook, not the budget battle, regardless of how vicious it gets.

The fresh slide in short- and long-term bond yields in recent weeks indicates that investors remain confident in the economic soft-landing scenario--that growth will stay slow enough to keep inflation at bay, and to warrant another interest-rate cut by the Federal Reserve Board.

Indeed, by one important measure--growth of the “monetary base,” a gauge of the banking system liquidity that funds the economy’s expansion--there is ample reason to expect more Fed cuts, experts note. The monetary base has been virtually stagnant since late May.

The bond market is all but certain of another Fed cut: The yield on new three-month Treasury bills, at 5.46% on Monday, is more than a quarter-percentage-point below the Fed’s benchmark short-term interest rate (the federal-funds rate) of 5.75%.

Yet economists note that the timing of the Fed’s next move with interest rates will almost certainly depend on the budget war. Fed Chairman Alan Greenspan has hardly disguised his willingness to reduce rates further once there is a credible balanced-budget plan in place.

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Thus, assuming Congress and Clinton won’t agree on a plan before November--in other words, they won’t agree until they absolutely must, to avoid a Treasury default--the Fed will probably decide to wait until then to cut rates.

So unless the economy heats up, the only risk in the bond market today is that investors may get too far ahead of the Fed in pushing market rates down, possibly leading to another modest rebound in rates in October as the political game plays out.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Slow Growth Ahead?

Many analysts watch the nation’s “money supply” for clues to the economy’s trend. Slower money growth often means slower economic growth. One money measure--the banking system’s monetary “base”--has barely budged since late May. Adjusted monetary base, in billions of dollars*:

Aug. 1995: $468.9

* Monthly averages of biweekly readings

Source: Federal Reserve Bank of St. Louis

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