MORGAN STANLEY: 'The Odds favour A Government Shutdown'

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The government managed to get us passed the “fiscal cliff.” But they did so by creating three more smaller, but still substantial “cliffs.”And according to Morgan Stanley’s Vincent Reinhart we’re likely to go over one of those cliffs, and it’s unclear what the consequences will be.

First, let’s review how we got passed the “fiscal cliff.”  Reinhart summarizes in a new research note:

The “resolution” of the sudden stop in the federal fiscal position that had been legislated for the end of 2012 created three risk events.  First, on or about March 1, the Treasury was forecast to run out of room under its statutory limit to borrow and run out of cash in its account at the Federal Reserve.  Second, absent legislative intervention, on March 1, sequestration kicks in, imposing across-the-board cuts in discretionary spending.  And on March 27th, budgetary authority to operate the government under a continuing resolution lapses, implying that the federal bureaucracy will have to cease the provision of all non-essential services.

On Wednesday, the House of Representatives passed a bill to suspend the debt ceiling.  And many are assuming some sequestration to hit.

However, Reinhart thinks that we are likely to see a government shutdown, or the freezing of non-essential services.  And because the market has gotten used to fiscal brinksmanship, a shutdown could be bad news because the markets don’t appear to have priced in the drag on the economy and shock to confidence.

From Reinhart:

The odds favour a government shut-down.  The experience of 1995 to 1996 reassures that the world will not end.  However, the drag on spending will likely be more significant than market participants expect.  With the countdown clocks on cable television put back into motion, consumer confidence could take a hit.  And, as always, the ratings agencies are a wild-card that could make this more of a market event, even if short lived.

Circling back to the start, the conversation at the policy-making scrum at the Conference centre at Davos shows the key problem for the US and Europe.  Market observers are bored by the details of the political debate.  Trained by last-minute bargains on both sides of the Atlantic, everyone assumes that nothing can go seriously wrong and compromise will win at the end.   If nothing can go seriously wrong, it should not be embedded in market prices.  And if market prices are not sending at least a yellow flashing signal of threat, politicians believe they have time to act.  Politicians who think they have time to act use it.  And what happens to market confidence in the absence of political action? We will find out.

We can hope for the best.

SEE ALSO: The ‘1994 Moment’ Is Keeping More And More Bond Traders Awake At Night >

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