A Congressional impasse over putting in place a fiscal year 2014 budget has resulted in suspension of ‘non-essential’ government services and furlough of approximately 800,000 workers. The government shutdown comes ahead of a mid-October need to raise the US debt ceiling which has potentially more important consequences.
Near term implications of the government spending stalemate are mainly economic. A shutdown for less than a week will have a minimal impact on Q4 growth and the market consensus is there are no lasting effects aside from some lost wages and perhaps weakened confidence.
The longer the US government shutdown goes on, however, the larger the economic impact will be. Beyond two weeks the impact would begin to accelerate, as most wages lost would not be made back and we would begin to see the secondary effects of productivity declines and business decisions put on hold. The shutdown in 1995 that lasted 21 days is estimated to have subtracted about 1% from GDP. This shutdown is unlikely to be protracted due to the upcoming debt ceiling deadline. As such, it is being viewed by markets as a temporary and non-systemic event.
At this time there is little incentive for negotiations on the budget to restart, suggesting that the impasse could last for longer. While shutdowns are neither complete (essential employees [i.e., armed services] and services [i.e., Social Security payments] will continue as normal), nor unprecedented; the divide between Republicans and Democrats is very large this time.
Ultimately, resolution will come down to politics; vocal constituents not receiving paychecks will put pressure on their representatives to reinstate funding. As an observer it is notoriously difficult to ever predict politicians’ actions, but it appears there is a good chance that a short-term, continuing resolution (budget proposal to continue at the 2013 spending rate) gets passed in the next week in order to set up for the debt ceiling negotiations. That is, moderate Republicans in the House could propose a continuing resolution (CR) that does not alter the Patient Protection and Affordable Care Act (ACA) and which passes with Democratic support.
Such a short-term CR will only keep the government funded for a few months, at which point the process will repeat itself. It is worth remembering that the Bureau of Labor Statistics closes during the shutdown and that Friday’s non-farm payrolls data will likely be delayed until resolution.
From an investment perspective we favour a neutral position in duration for now in case the shutdown is prolonged and the risk to the economy rises. We otherwise expect to shorten duration exposure should a resolution be imminent or if 10-year US Treasury yields move towards 2.5%.
The debt ceiling negotiation is more of a wildcard. While still not our base case, there is a growing risk that the bitter environment in Washington leads to a failure to raise the debt ceiling later this month. This would have severe consequences including the suspension of Social Security payments, suspension of payment to ‘essential’ government employees and contractors, and the risk of a technical default on US Treasuries.
The consequences of a missed Treasury coupon are potentially very negative; US Treasuries are unlikely to benefit from a flight to quality into safe haven assets, while high quality alternatives to Treasuries could perform quite well. All else being equal we will want to go into mid-October with a short exposure to duration as either a resolution (i.e. growth back on) or skipped payment will be negative for Treasuries, of which we already own few.
Lastly, it would be nice to get the announcement of the new Federal Reserve Chairperson out of the way in order to have one less variable impacting markets, but it looks like that appointment may be delayed due to there currently being higher priorities among those in Washington D.C.
Because of the uncertainty in Washington and potential risks of renewed fiscal headwinds to the economy, monetary policy will stay on hold for now and the probability of a policy change at the December (or October) Federal Open Market Committee meeting is falling. There are numerous Federal Reserve speakers this week and so we look forward to greater clarity over policy options.