Risk of US government shutdown should not be ignored

The coming days promise yet another fiscal cliff-hanger, with a risk of a government shutdown early next week. Although this is not our baseline scenario, in case markets are freaked out by a government shutdown we could see global markets shifting to risk-off mode.

Amid the focus on the Fed’s decision to delay tapering its bond purchases financial market participants should, at least for a while, shift their attention to the continuing fiscal soap opera in Washington DC. Thus, the coming days promise yet another fiscal cliff-hanger, with a risk of a government shutdown early next week.

In financial markets there still seems to be a belief in yet another last-minute agreement, Washington’s new normal – a view we share. However, such an attitude also implies that a shockwave could potentially be sent through markets if the tail-risk event materialises with Congress failing to clinch a deal.

According to some political observers, the likelihood of a government shutdown is the highest it has been in years due to the lack of bipartisan dialogue.

To avoid a partial federal government shutdown Congress will have to pass a temporary funding measure, a so-called continuing resolution, before the current authority expires 11:59:59 pm on 30 September. The underlying reason is that Congress for the third year running has failed to agree on a budget for the new fiscal year that begins 1 October. Without such a resolution, all non-essential government operations, representing around 20% of federal spending, would be forced to shut down 1 October until Congress passes a stop-gap funding bill.

With just a few days to go policymakers are still far apart on how to avoid a government shutdown. Last week the Republican-controlled House passed a stop-gap bill that would extend spending authority at the current funding level through 15 December but block funding for the Affordable Care Act, often referred to as Obamacare. But the bill stands no chance in the Democrat-controlled Senate, which is likely to send it back to the House “clean”, meaning with full funding for Obamacare. Senate leaders are expected to wait as long as they can to send a clean spending bill back to the House. House Republican leader John Boehner would then face a choice: put the clean Senate spending bill on the floor and allow it to pass with Democratic and moderate Republican votes, or attach some other Republican measure and return it to the Senate, with the shutdown clock ticking.

Thus, although we expect yet another last-minute deal, it cannot be completely ruled out that we will see a government shutdown on 1 October just because there isn’t much time to work out a deal that averts one.

A shutdown would not include so-called mandatory spending such as Social Security, Medicare, Medicaid, unemployment insurance, food stamps and interest payments on the federal debt. But it would mean that hundreds of thousands of government employees would be furloughed without pay, affecting everything from national parks to the Education Department to visa offices. Essential activities such as air traffic control, border security and federal prisons would not be affected, though. The Federal Reserve, which is self-funded, would also continue to operate.

Impacts of a government shutdown

As mentioned, we believe that a government shutdown will be avoided, possibly minutes before the deadline.

But in the tail-risk event of a shutdown, it would probably last no more than just a few days and any direct impact on the economy would likely be minimal, possibly reducing annualised US GDP growth by 0.2-0.3% point in Q4.

However, we are more concerned about the potential indirect impact of a shutdown. Thus, a major concern is that even a short government shutdown could seriously spook financial market participants as such an outcome could significantly reduce the perceived probability of an agreement to raise the federal debt ceiling in just a few weeks’ time.

To avoid a government default, Congress must agree to raise the debt ceiling by 17 October, the Treasury Department said yesterday. President Obama continues to warn that he will not negotiate fiscal policy as a condition for raising the debt ceiling. Republican leaders, on the other hand, promise a “whale of a fight” on the issue, attaching conservative priorities such as changes or a delay to Obamacare to a debt ceiling increase.

Although this is not our baseline scenario, in case markets are freaked out by a government shutdown we could see global markets shifting to risk-off mode, with sell-off in equities, a move lower in safe-haven government bond yields and a weaker USD versus JPY and CHF, while EUR/USD could remain roughly unchanged.

Eventually such a burst of market volatility would likely force Washington policymakers to find a solution to the urgent fiscal issues, while the Fed probably would postpone any tapering of its asset purchases into 2014.

The most recent shutdown was at the end of 1995 under President Clinton, when the government was shut down twice for 26 days combined. The Congressional Budget Office estimated those shutdowns shaved only about ½% point off US GDP growth in Q4 that year. However, if a shutdown runs for three or four weeks this time the overall impact on Q4 growth would, in our view, likely exceed 2% point because the economy is much more fragile today than in 1995-1996.

Our baseline scenario

Because engineering a government shutdown in 1995 and fighting over the debt ceiling in 2011 proved to be a popularity-losing effort, our expectation continues to be that both these fiscal issues will be solved on time. Thus, considering next year’s mid-term elections, we expect Congress to find a compromise, but perhaps once again in the 11th hour and 59th minute.

Once we get to the other side of the fiscal debate in an orderly way, we would expect confidence among consumers and businesses to improve. Alongside growing underlying strength in the economy, this is expected to pave the way for tapering of the Fed’s bond purchases at the 17-18 December FOMC meeting. For more analysis, see No taper – yet.

But again, this forecast is based on the expectation that the game of chicken on Capitol Hill doesn’t end with a splat.

The 2011 debt celing crisis – part I


The 2011 debt ceiling crisis – part II


The 1995/1996 debt ceiling crisis


The debt ceiling



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