Odds are good markets could look past a government shutdown if Congress fails to act this week, but the longer-term debt ceiling debate creates uncertainty and could hang like a cloud over markets until it's resolved. Lawmakers must act on a funding plan before the government faces a shutdown Friday. While there could be a temporary solution extending funding, the bigger issue of raising the debt ceiling may not be resolved for several more weeks. Treasury Secretary Janet Yellen has warned Congressional leaders that the debt limit could be reached sometime in October. The House of Representatives is expected to vote on the $1 trillion bipartisan infrastructure bill Thursday , already approved by the Senate. But Congress is not expected to move yet on the $3.5 trillion reconciliation bill, which is opposed by Republicans and some Democrats. Congress could also consider a continuing resolution to allow the government to function while the debt ceiling is resolved. "This is a jam-packed week, but some of this is inevitable, some of this was created on purpose. You need to create a series of deadlines and series of crises to force a resolution," Strategas head of policy research Dan Clifton said. "That is just how it works." Stocks ignore the shutdown threat for now Stocks are largely ignoring the possible government shutdown, but in the Treasury bill market, the 1-month bill yield has edged higher than the 3-month bill yield. Yields move opposite price, and investors are assuming there's more risk in the bill that matures at the end of October, Clifton said. The 1-month bill was yielding 0.06%, compared to the 0.03% for the 3-month bill. "The [stock] market just sees all this uncertainty, and says: 'Wake me up when you get there. We're going to focus on Covid, earnings and all this other stuff,'" Clifton said. According to Goldman Sachs, the stock market has not usually made big moves in prior government shutdowns dating back to 1980. The S & P 500 had a median decline of 0.1% on the budget authority expiration date, and a 0.1% gain during the shutdown periods. There was a median 0.3% move on the dates of resolution, Goldman found. "One notable exception was the most recent federal shutdown in December 2018, when the S & P 500 fell 2% on the spending authority expiration date. However, this decline was likely driven primarily by investor concerns about Fed tightening," Goldman strategists wrote in a note. The Fed is a factor this time But the Federal Reserve is in play this time as well, BTIG chief equity and derivatives strategist Julian Emanuel said. Last week, the Fed signaled it would be ready to move away from its $120 billion monthly bond-buying program soon, in its first step to reverse the easy policies put in place to fight the pandemic. The Fed also provided a new interest rate forecast that showed that half of Fed officials expect a rate hike next year. Previously, the Fed forecast its first rate hike for 2023. Emanuel has been expecting volatility and a correction this fall, and while the market typically bottoms in the first part of October, he said the debt ceiling debate could stretch out that time frame, depending on when the government runs out of money. "The problem here — and this is also the problem when thinking about the seasonality — you have all these things going on simultaneously," Emanuel said. "It's the shutdown, it's the debt ceiling, it's the infrastructure bill, and it's the bigger spending package. At the same time, and this cannot be discounted — this is the first time [Fed Chairman Jerome] Powell has erred on the side of hawkishness since late 2018, and that represents a major departure." Emanuel said the 5-year credit default swaps for U.S. debt were near record cheap levels in August but have jumped since, albeit to a still low level. "We were absolutely surprised, given all this uncertainty at the rip back higher in the stock market at the end of last week, but in our view it's more likely to test the downside, given the uncertainty overhang and given this idea the Fed is telling you rates have to go higher," Emanuel said. He expects the S & P could trade between 4,305 and 4,545 in the near term. It was trading at about 4,450 Monday. Analysts say risks from China's property developer Evergrande still hang over the market, as investors watch to see whether it will meet its debt obligations in the next month. A cloud of uncertainty Clifton said the uncertainty in Washington could drag on, and the road to resolution is complicated. "The only way the debt ceiling gets resolved, is if one party caves or you breach the debt ceiling. Caving here is not going to be easy," he said. In 2011, Standard and Poor's took the unprecedented step of lowering the AAA rating of U.S. debt because of political brinksmanship over the debt ceiling. "Our political economist has ascribed increasing risk to the upcoming debt limit and sees parallels to the experiences in 2011 and 2013," the Goldman strategists wrote. "The S & P 500 fell in 2011 but rallied throughout the 2013 debt limit experience. 2011 was plagued by the European debt crisis, S & P's downgrade of U.S. sovereign debt, and declining economic growth. In contrast, the macro environment was more favorable in 2013." In 2013, Goldman noted the government was shut down for 16 days, and the S & P 500 rose 2.4% during it. Clifton said some of the grand standing are the equivalent of Congressional "parlor games," but getting to the resolution may be difficult because of the divide in opinions. He expects the bipartisan infrastructure package to pass on Thursday. "I think that will create good-faith negotiations at the end of this week, beginning of the next week on the $3.5 trillion infrastructure package," he said. Clifton added the Senate will also vote on a debt ceiling government funding bill, and it will fail. The vote was expected later Monday. "The Democrats need to make a decision on how they want to proceed," said Clifton. The average shutdown has been just three days, but the last four have been longer, averaging 18 days, according to Goldman Sachs. In prior shutdowns, tech was the worst performing sector, posted a median decline of 0.9%, but then it rebounded by 0.4% in the week after the resolution, the bank found. The best performing sector ahead of prior shutdowns was communications, up a median 0.8%, but then it fell 0.5% after the resolution. Energy, which was the best performer Monday with a 3.6% gain, fell 0.5% before the shutdowns and 0.8% after, Goldman found. The S & P 500 itself has a median return of 0.4% in both the week before and after the shutdowns.
The U.S. Capitol Building is seen on July 23, 2021 in Washington, DC.
Kevin Dietsch | Getty Images
Odds are good markets could look past a government shutdown if Congress fails to act this week, but the longer-term debt ceiling debate creates uncertainty and could hang like a cloud over markets until it's resolved.