By Bill Hornbarger, Chief Investment Analyst, Moneta Group. . . .
I think it’s fair to say there is some confusion over what the difference is between the government shutting down and breaching the debt ceiling. On October 1st, the government shut down because Congress could not agree on how to fund the federal government. On an annual basis the House and Senate are supposed to agree on a number of appropriations bills (typically 12) to fund the federal agencies and set spending priorities (the budget). In recent years, the two chambers have been unable to agree on the budget and have resorted to a series of stop gap measures called continuing resolutions to keep the federal government and agencies operating. There is currently money to pay for these agencies but no agreement to actually fund them, hence the shutdown. To end the current impasse, Congress needs to pass a bill or series of bills to fund the government and the President would need to sign them. The current situation is not without precedent. There have been 17 different government shutdowns since 1976 with the longest lasting 21 days in 1995-96. There were six shutdowns in the 1970s that lasted longer than eight days and there was even a one day shutdown in 1982 when Congress couldn’t agree on funding the Contras in Nicaragua. In other words, this has happened before. It is painful if you want to visit a museum or need a drilling permit from the Department of Energy–not to mention the effects on those “non-essential” employees and contractors now furloughed. There will be an impact on the economy if it drags on too long, but the situation is not unprecedented. That is why the stock market so far has shrugged this headline off.
Breaching the debt ceiling is a whole other realm of dysfunction with much more severe economic consequences. If we hit the debt ceiling (projected to happen sometime between October 17th and November 5th) then the Treasury won’t be able borrow money to pay for spending that Congress has already approved. Under that scenario, Congress will have to vote to lift the debt ceiling (a very common occurrence) or the government will have to default on some of its bills; either to bondholders or Social Security and other entitlement program participants/recipients. Beyond the consequences of defaulting on those obligations, there is the practical matter of how and to what extent U.S Treasuries are used as collateral for repurchase agreements, escrowed and pre-refunded municipal bonds, hedging and a myriad of other purposes. If the current shutdown represents a disagreement with a neighbor then breaching the debt ceiling is a bar fight in a bad part of town with guns and other weapons. In trying to quantify the potential market impact of breaching the debt ceiling, I keep coming back to the days and weeks right after equities reopened in the wake of 9/11. The Dow fell a record 7.1% on the first day the markets reopened, and 14.3% in the first week after trading resumed. Besides an impact on equities, you would also likely see bond yields increase sharply if the debt ceiling is breached. I think something along these lines is possible if the headlines read “U.S. Defaults on Obligations.”
In closing, this is not a banner week for U.S. politicians or the U.S. economy. Let’s hope we can get through this and get it resolved quickly. The debt ceiling debate is much more important and I honestly can’t conceive of the politicians not getting it together and getting something passed to raise the debt ceiling. The consequences of not doing so are almost too great to imagine.
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The opinion expressed herein is that of MGIA and is subject to change without notice and should not be relied upon in substitution for the exercise of independent judgment.