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Expect lots of volatility as politics once again predominates. With both sides drawing lines in the sand and refusing to budge a federal shutdown seems increasing likely. The U.S. senate voted along party lines to extend financing till November 15th, now the ball is in the court of the U.S. House of Representatives .

Political Fallout

Who will get the blame for the shutdown? In my opinion, the U.S. public clearly sees this as irresponsibility on the Republican side. However, a Bloomberg National poll conducted on September 20-23 showed that there was a narrow majority blaming the Republicans. Nevertheless, the linking of the Obamacare to the renewal of the U.S. debt ceiling is seen as wrong. The cost for the Republicans might be high in future elections. Edward Luce in an FT article today pointed out that the decision by Newt Gingrich in late 1995 and early 1996 to shut down government played a major role in the defeat of his party to Bill Clinton in the presidential elections. Luce makes the case that this sort of a re-enactment of Custer's last stand by Tea Party Republicans over their absolute hatred of Obama.

Economic Fallout

Dante Chinni in a WSJ article today provided a good overview of how a budget shutdown would affect various regions of the countries. The impact overall would be modest at about 0.15% for each week in shutdown mode according to Morgan Stanley. However, this excludes any affect on the consumer confidence thus the impact is likely greater. Certain areas such as Washington DC, which has 29% of all jobs in government will get hit hard. Other areas include the Arlington Virginia area, Montgomery County in Maryland and parts of Arizona, Kentucky and Lousiana in which the number of government jobs exceed 10%. In most parts of the US, federal jobs only make up 2% of the workforce.

James Politi in an Financial Times article using figures from Goldman Sachs states that the impact would be about $8 Billion for each week the government is shut down.

Monetary Policy Fallout

The political showdown over fiscal policy would dramatically impact the calculus of future monetary decisions. Should an increasingly likely federal shutdown occur, the chances of a FED decision to roll back monetary stimulus are dramatically reduced. Thus, I don't see anything happening in the October and the December meetings is this were to occur.

In other words, the FED will be hesitant on rolling back monetary stimulus depending on how long the shutdown lasts. If it is only a few days, I still think they will not do anything in October since it is too close. December is more likely in this case. If the stand off lasts for a week or several weeks, I think politically they would have to postpone the decision until next year.

Emerging Market Fallout

The result in the short-term will be negative. However, the delay in cutting back U.S. monetary stimulus may give some emerging markets more time in the medium-term.

In other words, expect emerging markets to fall like other markets, but since something needs to be worked out in the short term in the US the decision to reduce monetary stimulus by the FED will need to be put off further in the future.

The best scenario will be a shutdown that is borderline. A little more than a few days but probably slightly more than a week. This will likely, as agued above result in the FED pushing the decision to next year.

Potential Trades

I would look closely at the emerging market ETFs that would get hurt the most in the case of a monetary stimulus reduction by the FED. India, Turkey and Indonesia are the best bets. EPI, the Indian ETF is pretty liquid in terms of options which would allow you to alter your risk/reward profile. For Turkey, TUR is the most liquid ETF with some options available. For Indonesia, IDX is a good choice but does not have any option contracts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: U.S. Budget Deadline Analysis And Fallout