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Despite the fact that over the past week news networks have almost exclusively covered cabinet post confirmation hearings and blizzard forecasts, another round of negotiations are beginning to heat up in Washington. Specifically, although lawmakers compromised on the American Tax Relief Act, three significant downside risks still remain:

  1. The spending sequester.
  2. The possibility of government shutdown.
  3. The debt ceiling.

As it stands right now, the self-imposed spending sequester will go into effect on March 1. According to forecasts by Macroeconomic Advisers, this massive across the board cut in government spending will reduce GDP growth "by 0.7 percentage points over the four quarters of 2013 (from 2.6 to 1.9) and by nearly a full percentage point over the second half of the year as the cuts build cumulatively." In other words, Congress is once again heading toward a down-to-the-wire agreement to resolve potentially disastrous self-imposed fiscal constraints.

Compounding the complex sequester conundrum is the fact that the government is currently operating based on a continuing resolution. This means that by April the federal government could run out of funds and be forced to begin shutting down. Despite the fact that the dispute in 1995 proved that government shutdowns are a dangerous game of political chicken, Congress seems be heading in that direction once again. According to analysis from Macroeconomic Advisers, such a shutdown could have disastrous consequences for the economy:

If, starting on April 1, a shutdown began affecting 36% of federal civilian workers, the static effect would be to reduce GDP growth in the second quarter by roughly ¼ percentage point for each week the shutdown lasted, and raise it a similar amount in the third quarter. The effect would arise mostly from the furloughing of non-essential federal workers whose production is valued at labor costs in the National Income and Product Accounts. If the shutdown was (expected to be) brief, the knock-on effects would be small. However, the longer the shutdown lasts, the broader its impact becomes and the more one must factor into the analysis multiplier effects as well as the escalation of uncertainty that would accompany a sustained disruption in government services and payments to federal contractors.

Essentially, for each week of government shutdown the GDP will grow ¼ percent less. Complicating this issue is the fact that the recent agreement to extend the debt ceiling until May is predicated on the need for a budget compromise. Another round of debt ceiling debates increases economic uncertainty and the likelihood that U.S. credit could face another downgrade. Projections indicate that this economic uncertainty could pose a 0.4 percent drag on GDP growth in 2013, even if the debt ceiling is eventually raised.

Adding all three of these growth retarding factors together, it would only take one month of government shutdown compounded with the sequester and debt ceiling uncertainty to turn our projected 2% annual growth in 2013 into an economic contraction. This assumes no further headwinds from Europe and sustained economic growth in Asia. In other words, thanks to political games the U.S. economy is not out of the woods. Even more disconcerting is the fact that should any or all of these factors precipitate, the Fed has almost no ability to offset the drain on the economy caused by fiscal policy.

With downside risks this high, it is extremely unlikely that the Fed will begin drawing down QE3 before significant fiscal resolution. However, should Congress and the President reach a "kumbaya moment" and resolve the sequester, agree on a budget and increase the debt ceiling, then absent substantial foreign pressures, investors should expect the Fed to begin "tapering off" QE3 in the second half of the year, most likely in September. Since the last sustained highs before the conclusion of QE2 occurred roughly four months prior, and that would likely coincide with market highs after a resolution of the various fiscal problems, investors should look to exit equities in May, if not before.

Source: Another Round Of Washington DC 'Let's Make A Deal!'