How The Markets Traded Ahead Of The Last 4 Fiscal Time Bombs

Congress comes back from their vacations this month. Among other things, they’ll have to address the debt ceiling as well as the expiring continuing resolution, which threatens to shutdown parts of the government after September 30.

This is all stuff that Americans have dealt with before. And to a certain extent, we’ve all been calloused by fiscal brinksmanship.

“So far, investors have been complacent about the risks posed by the looming budget fight,” said Nouriel Roubini. “They believe that — as in the past — the fiscal showdown will end with a midnight compromise that avoids both default and a government shutdown.”

“But investors seem to underestimate how dysfunctional US national politics has become,” he warned. “With a majority of the Republican Party on a jihad against government spending, fiscal explosions this autumn cannot be ruled out.”

So how should investors think about the coming debt limit and spending debate?

Perhaps we should consider what happened in the recent past.

Goldman Sachs economist Alec Phillips wrote about this in an August 16 note to clients:

Will Markets React After So Many False Alarms?

Since it is likely that the upcoming fiscal issues will be resolved at the last minute, it would be natural for some market participants to become more concerned as the dates approach. That said, after several rounds of fiscal brinkmanship over the last few years, markets may be somewhat desensitised to the headlines, at least until shortly before the deadline.

Not all fiscal showdowns are alike, and the potential market reaction depends on what is at stake. The debt limit debate in 2011 may have had the broadest effect, since the debt limit itself posed an immediate risk to the financial system, while the fiscal reforms being negotiated alongside the debt limit would affect the fiscal stance, sectors dependent on federal spending, and economic growth more broadly. For this reason (as well as unrelated factors, such as deterioration in the Euro Area around the same time) significant effects were seen in confidence, interest rates, and equities, among other measures.

By contrast, a government shutdown would have much more limited consequences and thus should also have much more limited market effects. Exhibit 5 shows equity volatility, the change in 10-year Treasury yields, and the change in a basket of equities with exposure to government revenues constructed by our colleagues in equity research. We would be surprised to see the perceived risk of a government shutdown — which we view as unlikely in any case — weigh on market sentiment, but it is possible that the debt limit could result in short-lived volatility around the deadline.

Like the title says: “Not all fiscal deadlines are created equal.”

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