Markets Are on Edge as Government Shutdown Begins This Week

Since the last edition of this column more than two weeks ago, the stock market has been on a wild ride as it made new all-time highs in the Dow Jones Industrials, S&P, Russell 2000 Index of small stocks and the Dow Jones Transportation Average as well. This was the result of the September 18 decision of the Federal Reserve not to taper its current stimulus program, which consists of the purchase of $45 billion a month in long-term Treasuries and $40 billion in mortgage-backed securities. After those new highs, the market then proceeded to decline during seven of the next eight sessions on fears of a government shutdown and the battle over raising the $16.7 trillion debt ceiling by mid-October.

The central bank justified its decision to not do anything on concerns over the recent sharp rise in mortgage rates, which they thought could be a hindrance to further economic growth. They cited strains in the economy from tight fiscal policy and those higher mortgage rates by saying that “the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market.”

They said that the economy was making progress, even in the face of tax hikes and budget cuts in Washington, D.C.: “Taking into account the extent of federal fiscal retrenchment, the committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy.”

And they still added that they were considering exactly when to cut back their current fiscal stimulus programs by saying that “the committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.” They justified standing pat by giving a gloomier economic outlook for growth by saying that they now see 2-2.3 percent gains, down from 2.3-2.6 percent in their June estimates. The downgrade for next year was even more severe.

Most policymakers also projected the first hike in overnight interest rates would not come until 2015, even though their forecasts suggested that they would likely hit their threshold for considering a rate hike as early as next year. The Fed reiterated that it will not start to raise rates at least until unemployment falls to 6.5 percent so long as inflation does not threaten to go above 2.5 percent. The U.S. jobless rate in August was 7.3 percent.

The markets started to decline from the September 18 highs immediately before the political drama in Washington, D.C. took center stage, due to a series of contradictory comments from various Fed officials in the days immediately following the no taper decision. For instance, the Kansas City Fed president sharply criticized her colleagues’ decision not to reduce the Fed’s bond-buying program, warning that it sowed confusion and risked the central bank’s credibility, given how convinced financial markets were that policy would be adjusted.

On the other hand, the dovish Chicago Fed president stuck in his two cents with the comment that “I can’t have tremendous confidence in our economic situation because at the moment the data does not provide us with reason to make major adjustments to the stimulus program.” No wonder investors were confused over the Fed’s intentions with opposite statements like these.

Those all-time highs of 15,676 for the Dow and 1725 for the S&P now appear as if they might be the high water marks for these indexes for a long time now that the political wrangling in Washington, D.C. has taken center stage.

As late as Monday, September 30, Congress was still in partisan deadlock over Republican efforts to stop the President’s health care reforms and as a result, the government was on the verge of mostly shutting down on Tuesday morning, October 1, the start of the new fiscal year. With the law that funds thousands of routine government activities set to expire at midnight on the last day of September, Senate Democrats defeated a proposal by the Republican-led House to delay the Affordable Care Act for a year in return for temporary funding of the federal government beyond September 30.

As a result of a partisan vote of 54 to 46 in the Senate, the proposal now goes back to the House, where the Republican leadership said that it would continue to seek a one-year delay in the Obamacare requirement for all individuals to obtain health insurance as part of a new spending bill. As of now, the Senate has rejected all House efforts to modify the health care law in conjunction with the spending bill.

Failure to reach an agreement to extend funding would force many federal agencies and programs to close or partially close for the first time in 17 years, which would result in up to one million federal workers on unpaid leave. The military would still function normally, but many civilian employees would be sent home.

A shutdown would continue until Congress resolves its differences, which could be a matter of days or weeks. The worst thing about the current situation is that it does not bode well for the next political battle, which is the far more consequential bill to raise the federal government’s borrowing authority. Failure to raise the $16.7 trillion debt ceiling by October 17 would force the United States to default on some payment obligations, an event so dire that it could cripple the economy and send economic shockwaves around the globe.

In any event, Monday brought the third quarter to a close, and the often treacherous month of September actually turned out pretty well, as the Dow rose 2.2 percent, the S&P was ahead by 3 percent and the NASDAQ was the hero with a 5.1 percent advance. For the quarter, the Dow was ahead by 1.5 percent, the S&P gained 4.7 percent while the NASDAQ rose by 10 percent, its best quarterly performance since the first quarter of 2012.

And for those government-shutdown historians out there, let it be remembered that during the Clinton-era shutdown from November 13, 1995, to November 19, 1995, the S&P actually rose by 1.3 percent; during the shutdown from December 15, 1995, to January 6, 1996, it was ahead by 0.1 percent, so we will have to see this week if history hopefully repeats itself this time as well.