In 2011, the US came close to a government shutdown, but it was narrowly avoided with a last-minute deal in August. We compare several indicators to show why there is a clear distinction between then and now. If the situations differ widely, will the economic and financial outcome too?
- Treasury yields are reaching much higher levels now, driven by the proximity of the tapering. Interestingly enough, QE2 had ended in June 2011 and markets were anxious about another rout of bond purchases by the FED (Operation Twist would follow). In spite of the threat of losing the AAA rating, Treasury yields fell sharply the weeks before an agreement was reached.
- Monetary Policy: the chart below highlights what was at stake. As can be seen, the Fed balance sheet was at a standstill when the chicken game started. In 2013 the Fed has acted preemptively and postponed its taper for fiscal reasons. The Fed is still purchasing at a rate of $85 billion a year and we do not see an end to this trend until at least December.
- News Flow Dynamics: One reason why Treasury yields declined was that the economy was decelerating sharply. As can be seen below, the news flow was unfavorable, while today's shutdown occurs when the economy is strengthening after a limited middle-of-the-year soft patch...
- Another way to highlight this is through PMIs. The ISM Manufacturing has been much stronger in 2013 relative to 2011.
- Stock Markets: in 2011, the S&P 500 had a very slow start and fell by 20% before an agreement was reached. Even if the index has fallen by 3% recently, it remains very close to its historical highs.
6 Reasons For Gridlock/Possible Exit: in 2011, the cause for gridlock was clearly linked to the dire fiscal position of the US (fiscal deficit at 8% of GDP) and the Sequester, which helped move the situation along. The opposition today is in regards to ideology and "partisan gamesmanship," or said otherwise, saving face. Republicans are bent on defunding or postponing Obamacare, which has already gone into effect, while Democrats are refusing to give any concessions. The issue this time around is that real, closed-door negotiations did not start until after the shutdown occurred.
Now, it seems that with the approaching debt-ceiling limit on October 17th, Congress will be forced to combine the issues in a Frankenstein deal, which will require concessions on both parts. The alternative will be Obama single-handedly raising the debt ceiling as the shutdown continues (not likely).
7 Crisis Fatigue and Late Scramble: The chart below shows how the sovereign CDS reacted to the political crisis. The green line shows that until very recently the shutdown/debt ceiling crisis was clearly outside of the main scenario of many investors.
8 Euro Crisis: In August 2011, the euro crisis reached a climax which spurred the interbank market / US money market crisis. The severity of the liquidity crisis triggered a sharp fall of the EUR across the board and led to a safe-haven related appreciation of the USD.
History rarely repeats itself, even less when the initial conditions differ as much as they do today. Therefore, how certain can we be that a bad outcome in October 17th (or at least a drawn out chicken game) would end up with:
- lower stock prices;
- lower treasury yields; and
- a stronger USD?
The charts below show some reasons to doubt this:
i. The correlation with the USD and US Treasury yield has now turned positive; and
ii. The correlation between stocks and bonds is no longer positive (even though the last point on the chart could be a case for caution).
Bottom Line: The initial conditions differ strongly when we compare August 2011 with today. Initially, it may look like the US economy is much more resilient now and seems much more able to shun a political crisis (news flow, stock prices, fiscal situation and monetary policy). Yet, contrary to 2011, there is no political artifact available to solve the crisis (sequester). The lingering belief that a last minute deal will be found is clearly a sign of crisis fatigue that is highlighted by the relatively low level of the Political Risk Index of Baker, Bloom and Davis. The main problem is that if the crisis worsens, there is only a limited probability that asset prices will replicate 2011's move as the current readings of correlations suggest. The idea of having lower stock prices, lower yields and a stronger dollar seems overplayed. We would rather prepare for lower stocks and higher yields. The main uncertainty would be on the USD. The recent re-correlation of the dollar with UST yield was Fed-related. If yields increase as a reflection of a higher political risk, the odds would be for a lower USD - especially since there is no euro-crisis going on.