More and more academics are using the Economic Policy Uncertainty index developed by Baker, Bloom and Davis. The index is based on three components: newspaper coverage of policy-related economic uncertainty, the number of federal tax code provisions set to expire in future years, and disagreement among economic forecasters as a proxy for uncertainty.
As can be seen in the chart below, the frequency of political uncertainty peaks has increased since the beginning of the Great Recession. The relationship is generally inverted: higher political uncertainty has often come along with a fall in the economic news flow. However, the chart below shows that the causality is far from straightforward. In some cases, the peak in uncertainty occurred after the economic trough (2011 and debt ceiling), while in other cases, it preceded it (late 2012 and the fiscal cliff).
The other information to be drawn from the chart is that in spite of the recent shutdown, the current reading of the Economic Uncertainty Index is below the levels of mid-2011 and late-2012. Either Washington is experiencing a crisis fatigue or the worst is yet to come.
A look at the medium run would give credence to this indicator. The charts below track the index with the US ISM Manufacturing. It suggests that the political risk has not been factored into businesses' expectations…yet.
In addition, the market risk aversion (VIX) and political risk may be associated, but this is not always the case (for instance, 2010). This is clearly what made the fiscal-cliff negotiations so different from those associated with the debt-ceiling: the VIX did not react to the Washington drama in late 2012 because there was no risk of US default. As the risk of a failure to reach an agreement on the debt ceiling mounts, the VIX and political risk index may recouple…
As US Treasury bonds are still a safe haven, I compare the risk index with UST yields. The chart below shows that the link was very tight in 2010 and 2011. The debt ceiling crisis, as is well known, drove US yields sharply downward in spite of the downgrade of the US public debt rating by one agency. The second chart on the right shows that the late-2012 fiscal cliff anxiety did not trigger a dramatic fall in UST yields.
The recent disconnect can in part be attributable to the "noise" associated with the Tapering. Yet, it is quite striking to see that in spite of the FOMC's decision to temporarily opt out, yields have remained relatively indifferent to the increase in the political risk index. It might be temporary but if the past is a guide, a spike in uncertainty similar to that of mid-2011 and late-2012 would suggest a risk-implied level of UST yield of 1.75%.
A lot has been written on the potential spillover of the shutdown on the US and global economy:
i. The impact on the US GDP would not be linear as the initial supply shock (fewer hours worked by non-essential services) would be followed by a demand shock (lower expectations, postponement of purchases), even though civil servants would end up being paid after the shutdown; and
ii. The impact on the global economy would be very limited as most of the public services that are closed relate to non-tradable goods. The only transmission channel would thus come through a rise in risk aversion associated with the debt ceiling (default). The financial channel could have a much stronger impact. In that sense, the chart below provides an interesting disconnect between the EUR/USD and the spread of US vs. Europe political risk index.
As can be seen, an increase in the relative political risk in the US would generally come with a stronger EUR/USD and conversely. There has been a strong disconnect in the recent past. Two readings are possible:
i. On the positive side, the lower uncertainty on Germany and in Italy (Letta winning the confidence vote with a wide margin) would make the spread converge towards the EUR/USD-implied level.
ii. On the negative side, this might not be enough, suggesting that the political risk in the US is underestimated. It would suggest being long Treasuries as one of our previous charts suggests.
Bottom Line: the quantification of the political uncertainty provides some interesting insight on the risk associated with the ongoing dual political crisis (shutdown and debt ceiling). There is a link between the news flow and the political uncertainty but the causality is not straightforward. Yet, risky assets will follow the political uncertainty when the economy is already weak and, above all, when the risk of default is mounting. In addition, the spillover of the crisis to a global market is not channeled through economic slowdown but mostly through the political risk perception. The link between the EUR/USD and the relative political risk on both sides of the Atlantic is telling.
The current reading of the political risk index is clearly that of a rosy scenario for the shutdown/debt ceiling ratio. Too much complacency? This time we will not be able to fall back on a sequester. In 2011, the opposition was focused on the means by which to reduce US public deficit. Today's opposition is much more politically polarized, making the likelihood of a resolution that much more difficult to conceive.
Were the gridlock to continue, the indicator will provide investors with a reliable signal on where UST yields and news flow might be heading to: DOWN.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.