Twin Paralyzing Factors Keep Washington Divided : WSJ

Congress deadlocked over debt as default looms : Reuters

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Analysis: The politics behind Boehner's two-step debt hike : Richard Cowan for Reuters

So a Reuters poll of market economists globally finds a majority resigned to the United States losing its Triple A debt rating. The depressing part of it is that they see a 20 pct chance of the U.S. returning to recession in the coming year, a prospect compounded by the political wrangling over how to cut the debt load. Story coming up

The US dollar is bearing the brunt of the debt row. Its losses are accelerating across the board today on jitters over the political standoff. It's hit a record low against the Swiss franc today, a traditional safe-haven buy. And Canadian dollar reaches a 3-1/2 year high, extending its gains of recent months. Euro, yen, Aussie all are gaining ground to hit session highs against the dollar. Looking at the US dollar index, you can see it steadily loosing ground since July 21 when market minds began to focus more sharply on the risks of default. Is the dollar the stalking horse, warning of what damage could be wrought if the debt crisis deepens? It's the territory of big professionals while Main Street's more likely to vote through the stock market. On that front, stocks are holding their ground - stalled might be a better word. It's earnings season and that gives an alternate narrative, but let's not forget TARP. Stocks can turn sharply and quickly when politics get ugly, so don't be lulled by this quietude. As for US Treasuries, you may have thought they would be the first to show investors fleeing U.S. assets. But our reporters at IFR note that the sheer size of the US Treasury market means that there is nowhere else to hide, and you might well see MORE money rushing into the short end of the Treasury curve if the debt crisis worsens. Indeed, the US 2-year Treasury note auction went well - demand more than three times stronger than supply -- showing there's plenty of appetite out there for US paper despite the political problems.

The White House Office of Management and Budget just tweeted that senior advisers would recommend a veto the Budget Control Act of 2011. Here's the statement: wh.gov

Here's the full text of the Budget Control Act of 2011, put forth by House Speaker John Boehner: 1.usa.gov

Want an Idiot's Guide to U.S. debt ceiling. Check out this cartoon video. www.reuters.com

What's the Worst Case Scenario if the U.S. defaulted on its debt? Boiled down to the basics, it risks triggering another global financial crisis and return to recession.
Treasury Secretary Geithner has called it "unthinkable" and potentially a catastrophe. But the financial policymakers really cannot tell for sure exactly what effect it would have. Remember, they did not anticipate the collapse of Lehman Bros would cause financial chaos and the worst recession since the 1930s. The transmission mechanism would be this: 1) Loss of confidence that the U.S. will repay its debts on time increases the riskiness of holding Treasuries, which is expressed in higher U.S. interest rates; 2) Since US Treasuries are a global benchmark (the "risk-free" rate) this could push up borrowing costs on a slew of debt worldwide, as well as corporate debt, mortgages, credit cards etc; 3) Higher borrowing costs will hit corporate earnings, causing steep losses in the U.S. stock market, which wouild spread to other global financial markets; 5) The U.S. dollar could decline sharply; 6) This massive repricing of financial assets would wreak untold consequences on banks and funds and financial institutions worldwide. Costlier money+market chaos when recovery remains fragile could well tip Western economies back into recession.
That is the fear, and why policymakers warn not to put the hand into the fire.

The Best Case Scenario -- They strike a deal to raise the debt ceiling and agree upon a medium-term plan to bring down the U.S. deficit through a combination of government spending cuts and tax increases/tax reform. Such an agreement would cause an immediate market rally, because it would provide some economic certainty whereby long-term investment decisions can be made, restoring investor and business confidence. This in turn would boost economic growth over time.

This graph shows how we got into this mess. The United States had a budget surplus at the end of the Clinton administration. During the Bush administration, spending far outpaced revenues. Budget costs rose by $2.2 trillion (think wars, bank bailouts and rescue plans, Medicare drugs program). Tax revenues fell by $1.8 trillion (the Bush-era tax cuts). Obama took over a big budget hole, which then got worse as he piled on more economic stimulus programs. These added $1.2 trillion in new spending costs, plus taxes were cut by a further $425 billion.

Here's a graph showing the inexorable climb in the U.S. borrowing. Without significant policy changes, the budget hole is forecast to grow rapidly, as retiring baby boomers start claiming Social Security and signing up for Medicare health benefits. The graph shows that on its current trajectory, the U.S. government debt load of $14.3 trillion would exceed $20 trillion by 2016. In other words, if we think we have a problem now, it's only going to get worse.

As I said earlier, the U.S. dollar is hurting from this debt debacle. How long will it take for the dollar to regain strength if the U.S. does avoid default and a credit ratings downgrade, one reader asks. The broader backdrop seen by many FX strategists is for the currency longer term to gradually weaken. The U.S. economy would have to show a significant resurgence in growth to alter that fundamental view. Short term, however, the outlook is better. The median forecast in Reuters July FX poll was for the dollar index to strengthen modestly to end this year at 76, around the level it has fluctuated since early May and up from its current reading of 73.5. Since that poll was taken July 1-6, before politicians hit an impasse in U.S. debt talks, I would wager it's a fair gauge of their expectations for the currency if the U.S. avoids the Big Double D (Default and Downgrade). Here's the FX report today

Glimmers of hope. White House adviser sees outline of a debt compromise. David Plouffe tells CNN there are a lot of similarities between competing Republican and Democcratic debt plans. Let's see if this gets them back from the brink.

Here's Plouffe's comments: www.reuters.com

Here's video of CNN interview with Plouffe: cnn.com