The Independent Market Observer

10/4/13 – How the Financial Markets Are Struggling to Process the Shutdown

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Oct 4, 2013 11:01:57 AM

and tagged Politics and the Economy

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The market has bounced around without a lot of direction over the past couple of days, popping up this morning after a rough showing yesterday. What’s going on?

Ultimately, stock prices reflect corporate earnings per share, and the bouncing prices can credibly be tied to expectations about what the government shutdown and potential debt ceiling confrontation will mean for those earnings. The changes in prices reflect the market’s attempt to come to grips with what we can expect to see over the next couple of quarters.

There has been a bit of a drop-off in prices over the past couple of days, with hints of something worse yesterday. The small drop-off so far is reasonable—I wrote the other day that the shutdown is costing the economy about 0.25 percent of GDP per week, roughly. With that taken out in the short term, a small downward adjustment seems reasonable, as fourth-quarter earnings will probably be a bit less than they otherwise would have been.

The hint of something worse came yesterday morning, when the S&P 500 dropped more than 20 points around noon, before reversing to close down about 14. There’s speculation that the drop was based on growing fears that the debt ceiling confrontation would result in a default on U.S. government debt—and that it was arrested by Speaker John Boehner’s statement (at about the same time the drop turned around) that he would make sure Congress didn’t allow such a default.

If that’s true, then the market was behaving rationally, starting to factor in the very real damage that a default could cause—and driving prices lower—before getting a statement from one of the principal actors in the drama that he wouldn’t allow that to happen—after which prices came back up.

We can see in real time how the market incorporates information and adjusts prices accordingly. What’s interesting today is that prices are up again, suggesting the market is becoming more optimistic about a less-painful resolution of the shutdown. Even as I write this, though, Twitter is abuzz with posts about how Boehner is holding a press conference—and prices are ticking down again.

Three takeaways today: First, Congress remains as deadlocked as ever on the surface, although multiple press accounts indicate that both parties are getting nervous, and that moderates on both sides are exploring possible deals. The serious negotiations have not yet begun.

Second, what the market does depends very much on the economy, which is very dependent on what happens in DC right now, on literally a minute-by-minute basis.

Third, the stock market could end up being only a minor part of the story.

Here’s why. According to an article just released by the Financial Times, the yield today on Treasury bills maturing at the end of October jumped from 3 basis points to 18 basis points, before dropping back to around 13 bps this morning. The FT story has a quote from the Treasury: “The fact that yields on Treasury bills that mature at the end of October are higher than bills that mature immediately before or after might suggest nascent concerns about possible delays in payments on those bills.”

This could be the big story here. Given the massive accrued debt, increases in the rates the U.S. government has to pay could be crippling. Disruptions in financial markets, such as for money market accounts that invest in this type of security, could disrupt the banking system. Unexpected side effects—the “unknown unknowns”—of a potential default are starting to appear. The fact that rates could sextuple, then drop back to “only” quadrupling, suggests that markets are indeed starting to take a hard look at the possibility of default.

So, when we talk about the effects of uncertainty on the markets, the stock market—one of the most liquid and transparent markets—may just be the part of the iceberg we can see. The real risk is probably somewhere underwater.

I was talking this morning with a reporter about how, in 2011, it took a real decline in the stock market to get Congress’s attention and force a deal, and my hope that it wouldn’t be the same this time. What I hope even more is that, when the iceberg of a stock market decline does show up, it’s not too late to turn the ship.

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