Government Shutdown: Where Do We Go From Here?
In and of itself, the government shutdown appears to be a limited market event. The indirect effect, however, is on the other main risk scenario for markets – the deal on the debt ceiling (which will need to be in place before October 17). An increase in the probability of breaching the debt ceiling would likely be destabilizing for the market. For one, the effect on growth will be far larger – our economists estimate that it would imply an immediate cut in spending equal to 4.2% of GDP (4Q average of the fiscal deficit). Second, it would raise the risk of a US sovereign default because the Treasury does not believe it has the authority to prioritize interest payments above other obligations. As such, with markets firmly focused on US fiscal matters - so where to from here?
The US government shutdown will likely be relatively short lived, but there is a risk that it could drag on for some time and complicate efforts to increase the debt limit in a timely fashion.
The Treasury must secure a debt-limit increase before the end of the month, and the T-bill market has already begun to price in concerns about a late payment.
Where do we go from here?
With the midnight September 30 deadline whistling by without any substantive discussions to avoid a partial government shutdown, the question now is how long it might last. The leadership of both parties does not want to risk the political fallout of a protracted shutdown, but the rank and file are not yet in the mood to compromise. It may take outcry from voters and donors – and a stock-market selloff – to force some resolution. Polls generally suggest the public hold Republicans more responsible for the shutdown, and divisions within the party have started to appear in news reports.
If the House leadership can convince a majority of members that extending the continuing resolution for a few months allows them to continue the fight without damaging the party's national aspirations too much, then a quick resolution may be possible. Conversely, if more conservative House Republicans are unwilling to approach the negotiating table without some concessions, the shutdown showdown could last for some time. And the longer the delay, the more worries would arise around the debt limit.
Our base case is that the shutdown will be relatively short lived, but there is a tail risk that it could drag on for some time. A shutdown that ends this week would likely have little net impact on the economy. If it lasted for a couple weeks, that could trim about 0.5ppt from 4Q GDP growth. As a shutdown drags on, however, multiplier, spillover and confidence effects would lead to a bigger negative impact, in our view. A full month’s shutdown could trim 2.0ppt from 4Q growth, especially if accompanied by a selloff in the equity market as we would expect.
Fed in wait-and-see mode
The duration of the shutdown will also be relevant for the Fed policy outlook. Concern about the impact of the fiscal cliff helped motivate QE3 last year, and more recently Fed officials have cited uncertainty about fiscal policy as a reason they deferred tapering in September. Our base case is for a small taper in December. The longer the shutdown drags on, however, the more likely the Fed would be to postpone tapering until 2014, especially if a short-term extension of the continuing resolution results in persistent fiscal uncertainty going into the mid-December FOMC meeting. And any kind of "fiscal accident" over the debt limit would almost certainly delay tapering. Chairman Ben Bernanke has noted that the Fed does not have the means to offset another fiscal shock.
Debt-limit fight is the main event
In our view, the debt ceiling itself has the potential to be much more impactful for the markets than a government shutdown. Last week, the Treasury Secretary offered updated projections of when the Treasury will exhaust its so-called “extraordinary measures,” which are a set of accounting solutions that allow the government to keep issuing Treasuries to the public even though it has reached the debt limit set by Congress. These measures involve temporarily reducing nonmarketable debt securities in order to free up space under the debt ceiling to continue issuing marketable securities to fund the deficit. Treasury will have used up these measures by October 17 at the latest, and at that point the government will have to operate strictly on a cash flow basis. We expect the Treasury to cut net bill issuance in coming weeks in order avoid breaching the debt limit, which would result in a drawdown of the government’s cash balance. The Treasury expects to only have about US$30bn in cash as of mid-October, which will only cover a week or two of deficit spending. Our projections show that it will be virtually impossible for the Treasury to get past November 1 without a debt-limit increase, otherwise the risk of default will rise to uncomfortably high levels. T-bill yields have risen this week, with the late October maturity bills currently trading about 8bp cheaper than the late-November issues, indicating growing concern about the possibility of a late payment.
A shutdown by itself should have only modest implications for the Treasury market, in part because investors had already priced in increased fiscal risks in the two weeks since the FOMC meeting, which served to focus investors on these downside risks. If the shutdown lasts more than a few days, however, we would expect a modest further rally in Treasuries, particularly in the 5-10y sector of the curve, and some widening in swap spreads. Data releases (except for those released by the Fed) could also be delayed. In the 1995 shutdown episode, for example, the December 1995 employment report was delayed by two weeks. A delay in payroll numbers could result in a decline in shorter-dated volatility, in our view.
The debt ceiling has the potential to be much more impactful for the market, and a protracted debt-ceiling battle could lead to a more meaningful rally in rates. We also expect T-bills maturing in late October and early November to experience further selling pressure as the debt-limit deadline approaches. However, we do not expect significant outflows from money funds as occurred in 2011, because the expiration of unlimited FDIC insurance on bank deposits has eliminated deposits as a safe-haven alternative to money funds for many investors.
Whither the USD?
While the FX market is confident that Congress will reach a timely agreement (mainly because they have done so in the past), risks of failure could be underpriced. The impact on the US dollar under different debt ceiling scenarios is not straightforward. In the run up to a debt ceiling deadline, dollar performance will likely hinge on the market’s conviction that a deal to raise the debt ceiling will be reached. If the markets believe a deal will ultimately be reached as the deadline approaches, the USD could depreciate even if equity markets decline amid a broader reduction in risk sentiment.
This situation would be similar to the past week where hedge funds sold USD as shutdown uncertainty increased (though most expected a deal) and equities declined. Such a scenario would favor the JPY and CHF against risk-sensitive, commodity-linked, and EM currencies. However, if investors become increasingly uncertain about the ability of politicians to reach a deal in time, the USD would likely appreciate alongside the JPY and CHF amid a broader decline in risk sentiment.
In the unlikely event that the US experiences a credit event as a result of a failure to reach an agreement to raise the debt ceiling, the dollar would likely be supported by safe-haven demand as global risk assets would decline significantly.
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