U.S. BARRELS TOWARDS A GOVERNMENT SHUT DOWN

Market’s worst fears of a Government Shut Down are about to come true.

While extending the Government funding to December 15, the House Republicans have asked for modifications that the Senate will not oblige. They have asked for a one year delay in President Obama’s heath care law and have proposed to repeal a tax on medical devices. The Tax proceeds would have funded the Obama Care plan. 

The Republicans have also voted to keep the troops fully funded.

The Senate will re-assemble at 2 PM on Monday to vote on the bill, the last day of the financial year. The Senate is expected to reject the bill, triggering a Government shutdown.

Even before the Bill had been put to vote in the House, both Reid, the Senate Majority leader and Obama had said that they would not compromise on the health care issues.

Senate Democrats are expected to send the bill back to the House to pass a stand-alone spending bill free of any measures that undermine the health care law.

What this all means is that government would be shuttered from 12:01 a.m. onwards on Tuesday. More than 800,000 federal employees, who are  deemed nonessential,  face furloughs. Many others will be without jobs.

History of shutdowns

If the Government ultimately shuts down on Tuesday, 1^st October , it is not going to do so for the first time.  The federal government has shut down 17 times before.

The last time it happened was in 1995-96 during Clinton’s first term. Republicans were roundly blamed for the incident at that time.  Their approval ratings plunged, and President Bill Clinton sailed to a re-election. This time the Republicans  feel that  they have a strategy in place that will shield them from public brickbats, especially with the bill to keep money flowing to members of the armed forces.

An important structural difference  last time was that before the, Congress had already passed numerous appropriations bills to finance main areas of government. Congress this time has passed none.

This time the Government has no such cushion. So this shutdown is going to be worse than before.

The derivatives data in the U.S. suggests that the markets are complacent. . A study of  option premium on  stocks that are highly exposed to government spending, like defence and healthcare  indicates that there is a sense of complacency around these stocks.

Fear priced into options on these stocks has dropped over the past few months to new lows versus the index options. Such stocks haven’t underperformed the S&P 500 over the past month. The recent fears of the markets on the budget deal don’t seem to be priced in the options. Since the Government shutdown is not discounted in the current prices, the chances of a fall are higher.

Gold, which thrives on uncertainty, rallied sharply during the government shutdown from Dec. 16, 1995, to Jan. 6, 1996. But that doesn’t automatically mean the precious metal will see buying from the uncertainty created by a shutdown.

In hindsight, these shutdowns are an opportunity for the investors who are waiting in the wings to get in.

The peak-to-trough decline associated with the shutdown of the U.S. government between Dec. 16, 1995, and Jan. 6, 1996, involved an S&P 500 drop of 3.7%, followed by an advance of 10.5% in the subsequent month.

President Obama, however, can avoid the shut down if he uses the Silver Bullet. He can unilaterally increase the debt ceiling. The President has the power to do this. It has not been used before, but can be done. Obama has nothing to lose, as he does not have to see re-election. But this is an eventuality, which the markets will not know on Monday.

How are our markets going to be impacted?

The shutdown of the U.S. Government is likely to negativey impact the global markets and our markets are not going to be any exception.

Apart from the negative implications of this event, we will have our own problems to tackle.

On Monday, the current account deficit for June quarter is likely to come in at around $23-25 billion. In June quarter of 2012, it was $ 17.1 billion. The CAD for March 2013 quarter was $ 18.1 billion. This higher deficit, though known, is not going to help matters.  As a percentage of the GDP, the figure of 4.8 to 5.4% is worrying.

This is a holiday shortened week as well. Our markets will be closed on 2^nd October, for Gandhi Jayanti. This means that traders will be reluctant to build positions and would prefer to be light. Brace for a further fall.

A $ 85 billion question: Will the Fed Taper?

The coming week will answer the biggest question that is on every investors mind – Will the Fed taper?

The Federal Open Market Committee (FOMC), the policy making arm of the U.S. Federal Reserve, will get into a two day  huddle next week ( September 17-18) and decide whether to start winding down its $85 billion a month purchase of mortgage-backed securities and longer-term treasuries.

Bernanke made it quite clear in his testimony earlier this year in May that the Fed will have to start winding up its aforesaid bond buying programme sometime later this year.

As a result of this announcement, the bond yields in the 10 year paper firmed up to the current 2.9% from the level of 1.9% prevailing in May.

As the yields in the U.S. rose, foreign investors demanded higher yield for their emerging market paper. The FIIs in India sold off with in a month whatever bonds they had bought in the calendar year till the month of May. The currency depreciated, which raised the hedging costs and as a result the desire for higher yields. We all know how the Rupee tumbled to 68.8 versus the U.S. Dollar.

Courtesy a series of steps taken by the new Governor of Reserve Bank and resumption of fresh buying by FIIs the Rupee has clawed back to the current levels of 63.46 to the Dollar.

As things stand today, with the Nifty at 5828, and having seen a plunge to the levels of 5118 in August, it is perfectly logical for the investor to get worried about the Fed taper.

The Fed’s balance sheet has ballooned to about $ 3.6 trillion with all the quantitative easing. All this liquidity has helped increase the investments in risk assets such as equities globally. As this liquidity dries up markets could suffer.

The Fed has laid down clear targets of Unemployment Rate of 7% and an inflation rate of 2% for it to stop the stimulus to the economy. The Unemployment rate currently is at 7.3%. So it must begin to wind up the easing this month if it is to meet its March 2104 target of ending the stimulus.

The economy is not showing the signs of robust growth which were evident in June. The average job creation for previous months was around 1,99,000. The revised data is much lower at 1,64,000. The retail sales, which power the U.S. economy also grew at a much slower pace in August at  0.2% as against expectations of 0.5%.

While the Fed may have to begin tapering from this month, it has to ensure that it does not smother the growth of nascent U.S economy.

We believe that the Fed could taper but will do an only notional job of it. We think winding up the stimulus by $ 10 billion is likely to be in order. 

While a lot depends on how the markets perceive it, our sense is that the markets have already priced in a $ 10 billion taper. Anything less than that will surely come as a pleasant surprise and will buoy the markets.

Since the Fed buys both the treasuries and mortgage backed securities, the cut is likely to be in the treasury buying as housing is too important for the U.S economy to be touched at this point of time.

But in the event that the Fed does not taper, the markets will rock .

Vinod Sharma

Business Head - Private Broking & Wealth Management