US Shutdown Update

The debt ceiling and government shutdowns are two separate and distinct issues in the US. Yet problems dealing with the two issues are very much correlated, since the root cause is usually a dysfunctional or divided government. Here, we focus on the government shutdown. We will deal with the debt ceiling in another piece.

RECENT DEVELOPMENTS

The Senate will finally make an effort towards ending the US shutdown. Senate leaders have agreed to hold votes this Thursday on two competing bills and marks the first time that it has acted during the entire length of this shutdown. One includes $5.7 bln in funding for the wall while the other would reopen the government through February 8 with border funding to be decided later.

While neither bill is likely to solve the impasse, this could be the start of a negotiation process. The first plan is unlikely to pass in either the Senate (60 votes needed) or the House. The second plan is expected to pass in the House but not in the Senate. Even if it is passed in the Senate, there are unlikely to be enough Republican defections to override (67 votes needed) a likely veto by President Trump.

Meanwhile, hundreds of IRS workers have obtained permission to skip work due to financial hardship. At least 30,000 IRS workers had been ordered to work without pay to process tax refunds. Press reports suggest that other workers will not show up in protest. Either way, this is another channel in which consumption could be crimped since many Americans count on tax refunds to fund big ticket purchases.

Fitch gave a timely warning of a possible cut to the AAA rating for the US. The agency said that if the shutdown continues to March 1 and the debt ceiling becomes a problem a couple months later, it may need to consider whether the policy framework and the inability to pass a budget are consistent with a AAA rating for the US. Again, the two issues are separate and distinct, but Fitch is simply acknowledging that the current shutdown likely heralds a tough slog ahead to increasing the debt ceiling.

 

A BRIEF HISTORY LESSON

The US government is typically funded by appropriations bills. Each fiscal year, twelve regular appropriations bills must be passed by October 1 to keep the government fully funded and running smoothly. If a regular appropriations bill is not passed by the deadline, Congress can pass a so-called continuing resolution which generally continues the already existing appropriations at the same levels as the previous fiscal year for a set amount of time.

A shutdown occurs when an appropriations bill or a continuing resolution cannot be passed. This failure could be due to Congressional inability to either pass legislation or to override a veto of said legislation by the President of the United States. This leads to what is called a funding gap, which means that the federal government must shut down. In the event of a shutdown, the affected government agencies are required to furlough non-essential personnel and either stop or severely limit their activities.

In 1976, the current budget process was enacted. Since then, there have been 21 shutdowns of varying length. One came during Gerald Ford’s administration, lasting 10 days. Five came during Jimmy Carter’s administration, ranging from 8-18 days. Eight came during Ronald Reagan’s administration, ranging from 1-3 days. One came during George H.W. Bush’s administration, lasting 3 days. Two came under Bill Clinton’s administration, lasting 5 and 21 days. One came during Barack Obama’s administration, lasting 16 days. Lastly, three have come during Donald Trump’s administration, ranging from 1-32 days (and counting).

The current shutdown is occurring because Congress was able to pass only five of the twelve regular appropriations bills last fall. The other seven were instead covered by continuing resolutions that lasted until December 21. When those expired with no other appropriations bills or continuing resolutions to replace them, the current shutdown was triggered.

There is no rule of thumb with regards to when a shutdown starts to really impact the economy. Clearly, ones that last less than a week would have close to zero economic impact. When the length starts getting up to two weeks or longer, then it starts to get more serious as paychecks start to be missed. The current shutdown, going into its second month, could be a game-changer. If the shutdown persists through this Friday (which seems likely), Federal workers would miss their second paycheck. This is unprecedented.

 

ECONOMIC OUTLOOK

The economic costs of the shutdown are mounting. This month, the head of Trump’s Council of Economic Advisors Kevin Hassett estimated that the shutdown reduces quarterly GDP growth by 0.13 percentage points for every week that it lasts. This is greater than initial CEA estimates of 0.1 percentage points for every two weeks that it lasts.

Today, Hassett warned that zero growth is possible in Q1 if the shutdown continues. However, he added that the chance of a recession in 2020 is “very very close to zero.” The first part is very negative, much more pessimistic than the market is. On the other hand, the second part is much more optimistic than the market is. We think most analysts would agree that the odds of recession in the next year or so were already high even before the shutdown.

In case anyone is wondering about the US jobs report, this is from the Department of Labor’s website: The Department of Labor, including the Bureau of Labor Statistics, is funded through September 30, 2019. BLS is operating as usual and expects to follow its announced release schedule. The January 2019 Employment Situation will be published as scheduled on February 1, 2019 at 8:30 a.m.

It’s worth noting that the most recent weekly jobless claims number was for the survey week (the one that includes the 12th of the month). Initial claims fell to 213k and suggests a solid number for January. Consensus for NFPs currently is 160k vs. 312k in December. According to guidance from the BLS, federal employees who are furloughed will be counted as employed. Furthermore, those who are working but not receiving pay will also be counted as employed. Bottom line: the shutdown’s impact on the jobs data should be limited.

On the other hand, the Commerce Department is closed due to the shutdown, so its data releases have been postponed. These include (but are not limited to) trade, inventories, retail sales, personal income and spending, and GDP. This means that policymakers and markets are flying partially blind. The Atlanta Fed’s GDPNow model is currently tracking 2.8% SAAR growth for Q4. The New York Fed’s Nowcast has Q4 growth at 2.6% and Q1 at 2.2%. However, we note both are now working with incomplete information due to delays in data reporting.

We all know about the 800,000 government workers affected by the shutdown but we haven’t seen any numbers about the federal contractors until recently. Some press reports suggest the partial shutdown impacts up to one million contractors. Furthermore, some calculate that the shutdown could impact payments to these contractors somewhere in the neighborhood of $200 mln per day.

 

INVESTMENT OUTLOOK

The implied yield on the January 2020 Fed Funds futures contract is currently around 2.44%. While up from the 2.22% trough on January 3, this yield is far short of the 2.95% peak in early October. Still, it’s a good sign that markets have moved away from pricing in a cut this year in favor (albeit modestly) of a hike instead.

We downplay the risks of US recession near-term but acknowledge that the risks are rising. The protracted shutdown simply adds to the uncertainty facing the Fed, and so we see very low likelihood of any hikes until mid-year. We still look for two Fed hikes this year (most likely on June 19 and December 11), though this is dependent a “no recession” scenario. While much depends on the US economic performance in 2019, we think US rates are likely to rise more than what markets are expecting.

Our rate outlook is dollar-positive and equity-negative, to state the obvious. Indeed, we retain our bullish dollar call for 2019 but we expect to be tested many times on our conviction until current recession fears fade. Shorter-term, we think the dovish tilt in the Fed’s messaging could weigh on the dollar and lead to further weakness in early Q1.

Again, this is all predicated on a continued economic expansion in the US. If the facts change and the economy slows or goes into recession, then the Fed will have no choice but to alter its rate path and cut rates. If so, this would be a game-changer. Why? Because the policy mix would change from the current dollar-supportive one (tight monetary and loose fiscal policy) to one that is dollar-negative (loose monetary policy and tight fiscal policy).