Analyst: Govt Default Shutdown Will Panic Stock, Bond Markets

Friday, 08 Apr 2011 07:14 AM

 

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Investors face two possible U.S. government shutdown scenarios, one of limited impact on markets, and another so potentially devastating that analysts are struggling to assess it fully.

Neither is sure to occur, but the limited-impact version seemed distinctly possible on Thursday as Democrats and Republicans argued over the federal budget. It would involve the expiration at midnight Friday of a stop-gap spending measure known as a continuing resolution, or CR.

The nightmare shutdown scenario, still a few weeks away, would involve Congress failing to raise the national debt ceiling and possibly an unprecedented government debt default.

"A CR shutdown is a big deal, but not Armageddon," said Chris Krueger, a policy analyst at financial group MF Global.

"A default shutdown ... would result in panic in both the equities and bond markets," he said.

With these scenarios and the $1.4 trillion federal budget deficit as a backdrop, the game of fiscal chicken under way in Congress is likely to go on for months.

Here is a look at the risks ahead and the political thread running through the fiscal debate to the 2012 elections.

FISCAL 2011 BUDGET

The drama currently under way in Congress is over spending in fiscal 2011, which is already 6 months old.

On Friday, a continuing resolution that is keeping the government running in the absence of an approved FY11 budget, will expire. If it does, the government could shut down.

If that happens, nonessential government services would stop and some sectors of the stock market could take a hit, with the severity depending on the shutdown's duration.

Around 800,000 workers could be idled and activities ranging from processing of tax filings and Small Business Administration loans could be suspended in a shutdown, a senior U.S. official said Wednesday.

"Our odds remain above 50 percent that the government will not shut down on Saturday, though it is close to a jump ball," Krueger said.

VULNERABLE SECTORS

In a CR shutdown, some stock sectors could be hurt.

• Energy. Drilling permit processing could cease.

• Healthcare/pharmaceuticals. The government's drug and medical technology review process could be delayed, but analysts doubt a serious disruption.

• Tourism/travel. Processing of passports and visas could stop, while national parks and monuments would close. Both of these events did occur the last time the government shut down, for three weeks in 1995-1996, and they reportedly cost airlines and tourist businesses millions of dollars.

• Contractors. Companies that do business with the government could suffer project complications and payment delays, with the Washington, D.C., area especially vulnerable.

• Manufacturers. U.S. authorities in the 1996 shutdown failed to scheduled standards for lights and lamps. That may have caused manufacturer supply chain disruptions.

• Financial services. Work on 3,500 bankruptcy cases was reportedly suspended in 1996. This time around, the possible impact of a shutdown on banking and market regulators working to implement last year's Dodd-Frank laws is unclear.

EQUITY MARKETS COULD SUFFER

"The biggest impact from a government shutdown is likely to be felt in the equity markets," TD Securities analysts said in a research report earlier this week.

The Dow Jones Industrial Average fell a little more than 1 percent on Dec. 18, 1995, the first trading day after the last shutdown started. But then the benchmark index more than regained its lost ground as the shutdown wore on for weeks.

Goldman Sachs has projected that a shutdown lasting more than a week this time around could result in $8 billion per week in missed federal spending, dragging on economic growth.

From a political standpoint, the outcome of the fight over the continuing resolution will be critical as a signal of which way the next contest may go.

"People who follow the markets are paying attention to the CR because what happens with that has implications for the debt ceiling," Krueger said. "It's all tied together."

With that in mind, shares could initially weaken on news of a shutdown.

DEBT A WORRY

If the government shuts down, as it did in 1996, there will likely be no Treasury market reaction, but should the debt ceiling be reached, Treasurys could rally.

In the past the government, at its quarterly announcement on Treasury issuance, has cut the size or even suspended bond issuance in order to stay under the debt limit, said Marcus Huie, U.S. rates strategist at Deutsche Bank in New York.

If this happened again, Treasury prices could rise.

The Treasury Department said Monday it will hit its $14.3 trillion borrowing limit no later than May 16, pressuring Congress to raise the debt ceiling to avoid a default.

Republicans are using the debt ceiling issue as leverage to demand sharp budget cuts that Democrats want to minimize.

If Congress failed to raise the debt limit, the Treasury could put off a default until early July. One way to do that might be to reduce or suspend new debt issuance.

A drop in short-term debt issuance is unsettling to securities-lending markets out of concern that covering repo agreements could become more difficult, analysts said.

If the ceiling was not raised, the government might for the first time be unable to pay its bills. Such an event would undermine so many economic fundamentals worldwide that analysts say the full impact is difficult to judge. One outcome, they said, could be a shutdown of unprecedented scope.

FISCAL 2012 BUDGET

Despite shrill Capitol Hill rhetoric, especially from Tea Party Republicans, analysts say the debt ceiling will likely have to be raised, but not before both parties have scored political points each sees as vital ahead of 2012 elections.

Republicans sense that the economic recovery now under way means they will be unable to run against Democrats on jobs and growth, but the deficit is a promising issue, analysts said.

Republicans Tuesday unveiled a politically risky budget plan for fiscal 2012, starting Oct. 1, that would address the deficit by cutting healthcare for the poor and the elderly.

The Republican plan differs starkly from President Barack Obama's FY12 spending plan unveiled in mid-February, but the fight over next year's budget is not yet fully engaged.

The FY11 budget and debt ceiling debates are setting the stage for both the FY12 budget struggle and the elections.

Republicans hope that their aggressive budget-cutting will impress voters concerned about the deficits, though polls show Americans oppose many of the cuts Republicans are offering.

Democrats hope GOP proposals and Tea Party demands for deeper, faster cuts in popular domestic programs such as Medicare will prompt a voter backlash against Republicans.

© 2014 Thomson/Reuters. All rights reserved.

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