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Wall Street uneasy in face of government shutdown

Adam Jeffery | CNBC

Wall Street has wearily grown accustomed in recent years to periodic market flare-ups caused by fiscal fights in Washington.

But the current battle — and the looming threat of a government shutdown on Tuesday — is beginning to cause greater unease than past political disputes and may rattle markets when they reopen on Monday.

For investors, the chief fear is that a government shutdown would set the stage for a more momentous battle over the so-called debt ceiling. If there is no agreement to raise the borrowing limit by mid-October, the government will not be able to issue more bonds and could default on its outstanding borrowing.

(Read more: Wall Street's shutdown fears may be overblown)

While Congress in the past has waited until the last minute to raise the debt ceiling, a growing number of analysts say that the political disagreements appear to be more intractable this time around.

"The threat of a default, however remote, seems to be on the table now," said Gregory R. Valliere, the chief political strategist at Potomac Research Group.

Still, there have been government shutdowns in the past and the markets have quickly recovered. At the end of last year, Congress approved legislation that averted a series of tax increases and budget cuts known as the fiscal cliff. Stocks fell sharply in the days leading up to that agreement, but they rebounded quickly.

And in past debates over budget issues, investors were faced with other big crises that heightened the sense of risk, including the European debt crisis and a potential double-dip recession in the United States.

Since the beginning of this year, most other serious threats to the global economy have faded and Wall Street has habituated to relatively smooth sailing. The benchmark Standard & Poor's 500-stock index is up over 18 percent this year.

In recent weeks, the primary concern among market participants has been the Federal Reserve and its decision about whether to slow down, or taper, the bond-buying programs that have been used to stimulate the economy.

The Fed's decision to hold off on tapering was still the main topic of conversation on trading desks at the beginning of last week. But as the week went on, more and more investors began to tune in to the standoff between House Republicans and Senate Democrats. Stocks fell on Friday to close out the first down week in a month.

The main focus on Wall Street is the possibility that the government will stop making payment on its outstanding bonds when the current borrowing limit is reached, which is expected to happen on Oct. 17.

(Read more: Debt ceiling fight won't spur volatility—yet: Pro)

Treasury bonds are viewed as the bedrock of financial markets, thanks largely to the assumption that the United States will always pay its debts. Most analysts say that if that were thrown into question, the consequences would be catastrophic, and largely unpredictable.

"Even if it's a brief failure, it would forever be a signal to the market that you can't trust the United States government to make its payment when it's due," said Millan Mulraine, the director of United States research and strategy at TD Securities. "That would shake the foundations of the global financial system."

Before Congress can turn its full attention to the debt ceiling, it will first have to deal with a resolution to keep the government open when the new fiscal year begins on Tuesday.

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House Republicans passed legislation over the weekend that would keep the government operating only if funding for President Obama's health care bill is delayed for a year and a tax on medical devices is permanently repealed. The Democrats who control the Senate have said they will not agree to those conditions.

Most Wall Street economists have said that the consequences of a temporary government shutdown would be relatively insignificant, particularly because spending on essential services — a large portion of the budget — would continue. Citigroup economists estimated on Friday that a one-week shutdown would probably cause a 0.1 percent hit to the national economy.

But many strategists say that the outcome of the debate over the shutdown is important because it will set the backdrop for the battle over the debt ceiling. Mr. Mulraine said that a disagreement this week would most likely mean that "both sides are so entrenched that making progress on the debt ceiling would be much harder."

In contrast, Alec Phillips, a Goldman Sachs economist, said Friday that a shutdown could "ease passage of a debt-limit increase" because House Republicans could lose their bargaining leverage.

Led by Speaker John A. Boehner, House Republicans have already said that they would demand even more concessions in order to agree to a lifting of the debt ceiling, including changes to environmental and financial regulations.

(Read more: The problem with Wall St. greed 5 years post crash)

Economists at Bank of America and Capital Economics wrote on Friday that the focus on President Obama's health care legislation makes the positions of both sides more intractable now than they have been during other budget fights.

"We have no idea exactly how this standoff will be resolved, and even less of an idea exactly when any agreement might be reached," the Capital Economics team said in a note to clients on Friday. "At this stage, we would be lying if we said we were confident of a positive outcome."

If the disagreements persist, the reaction in the markets is likely to become much more pronounced as Oct. 17 draws closer. Mr. Valliere said that in the past, sharp swings in the markets helped to eventually push politicians toward a compromise.

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