With even the most compromising politicians on both sides of the aisle admitting at least a brief government shutdown is inevitable (and according to Stone McCarthy the shutdown will hardly be brief and will affect the timely release of such major economic indicators as construction spending, factory orders and the employment number on Friday), the next question arises: how have markets responded to not only shutdowns, but also debt ceiling impasse (with the memory of August 2011 still very vivid) in the past. Here is the full answer from Deutsche’s Dominic Constam.
Market reactions to prior shutdowns and debt limit events, from Deutsche Bank
Treasuries rallied most of the week, as lawmakers debated how to fund the federal government to avoid a shutdown. We analyzed market reactions to prior government shutdowns and debt limit events. The longest government shutdown occurred between December 15, 1995 and January 6, 1996 for about three weeks. There was a five-day shutdown in November 1995. In 1980s, government shutdowns were more frequent, but lasted shorter in most cases.
There have been far more frequent debt limit increases in recent years. From the financial market crisis in 2008 to present, the debt limit was raised seven times. The overall market reactions to the events were:
- Treasuries rallied modestly into shutdowns, and sold off afterwards. The curve was mixed. In recent rallies, curve tends to flatten, and vice versa. When rates were higher in 1990s and 1980s, curve tended to steepen in rallies, as perhaps the front end outperformed in flight-to-quality trades. In the 2011 debt limit increase, Treasuries rallied all the way through, due to the S&P downgrade on Treasuries and the sell-off in risk assets.
- Swap spreads were stable or slightly tightened during the shutdowns, and marginally widened afterwards. Around debt ceiling events, spread movements were mixed with a marginal widening bias on average.
- Stocks tended to sell-off prior to the shutdowns/debt limits, and recovered afterwards.
- The dollar (as measured by the DXY index) tended to weaken into the shutdowns/debt limits, but strengthen afterwards.
In a shutdown scenario, government agency-compiled economic data releases could be delayed, while essential services, such as Treasury auctions, interest and principal payments on Treasury securities will not be affected. Some federal workers could be furloughed. The most recent government shutdown occurred in late 1995 to early 1996, and lasted about three weeks. Payroll and retail sales data were delayed during that period.
In his letter to Congress on September 25, Secretary Lew forecasted the extraordinary measures to “be exhausted no later than October 17.” The Treasury will have only approximately $30 billion in cash balance. Therefore, the hard deadline for the debt limit increase could be in late October to early November. Treasury needs to make some large payments on November 1 (e.g., Social Security, Medicare, Military and veteran pays, etc.). So November 1 is a critical date. Treasury securities, bills, short-dated coupons, and STRIPS, maturing in late October and early November have cheapened this week on debt limit concerns. CDS spreads have widened. We expect a debt ceiling deal, and no US Treasury CDS event to occur.
In recent debt limit episodes, prioritization of payments has been discussed. In reality, it’s difficult to prioritize hundreds of monthly payments that go out of Treasury. In April 2013, House Republicans passed a bill that prioritizes payments. It grants Treasury the authority to borrow to fund principal and interest payments on public debt and the Social Security trust funds. President Obama indicated that he would veto the measure if t were to be approved by Senate.
- In eight of the last 12 times heading into a debt limit deadline, rates market rallied. The 10y yield ranged 3 to 26 bps lower during the five days before
the debt ceiling resolution.
- Yields tended to rise after the resolution. Also in eight of the last 12 episodes, 10y yields ranged between 1 and 27 bps higher ten days later.
- Swap spreads shown a widening bias prior to the resolution and a tightening bias subsequent to it. Tighter spreads coming out of a debt limit increase were observed in eight of the last 12 episodes.
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Finally, anyone who thinks they have a bearing on the political theater may be wise to reevaluate. For once, Washington’s theattrical muppetry may have run out of control. From Stone McCarthy: “At this point, we don’t see how this gets resolved quickly. We also don’t know what the implications are for the battle over the debt limit. Some observers think linking a fight over Obamacare to the CR will allow the Tea Party to get it out of its system, so to speak, and as a result, it’ll be easier to get an increase in the debt limit. We’re not so sanguine. That scenario might make some sense if Senate Democrats and the White House made some concessions on the ACA in order to prevent or end a government shutdown. But right now, that doesn’t seem likely.