Another month, another looming government shutdown. If Washington does not act by midnight on February 8th, we could face yet another shutdown. The continuing resolution that was passed to end the brief shutdown in January only keeps existing levels of government funding going until then. Any bill to fund the government needs 60 votes in the Senate, and Republicans only have 51 seats, so progress requires compromise between Democratic Senators, Republicans and the White House.
There are two additional deadlines looming that up the ante in the latest partisan squabbling. First, the Deferred Action of Childhood Arrivals (DACA) program, which protects the "Dreamers" from deportation, ends on March 5th. There is consensus from both parties that there should be a fix that allows Dreamers to stay in the country, but the issue is entangled with more contentious aspects of immigration policy, and funding for a border wall. Second, the debt ceiling needs to be raised sometime in the first half of March. Secretary Treasury Mnuchin has formally requested that Congress raise the debt ceiling by the end of February. Neither of these issues is pressing by February 8th. But, if Congress passes another short-term continuing resolution, which is likely, it could set up a very contentious situation in a few weeks' time.
We do not expect the likely eleventh hour showdown to be overly damaging to either markets or the economy. However, with heightened volatility and substantial price swings across major indices around the world over the past week, it’s one more event that adds uncertainty to the markets. Fear is a big part of market sentiment, in particular, fear of the unknown. Given the number of eleventh hour showdowns on both government shutdowns and the debt ceiling in recent years, these situations have become "known unknowns" for financial markets.
There have been 19 “funding gaps” since 1976, only a few of which has resulted in full government shutdowns. On average, markets have shown modest weakness over the period of the closure, with the S&P 500 down 0.6% on average. However, the index rose in 44% of past government shutdowns. In fact, during the three longer shutdowns under Clinton & Obama, markets rallied.
In the event of a shutdown, essential services will remain in place, including air-traffic controllers, armed forces, and law enforcement. The Federal Reserve is not funded by Congress, so it too would remain open for business. But, many “non-essential” operations would be closed, like national parks, statistical agencies and the IRS, causing disruption in the lives of many Americans, particularly those federal employees who will not be paid during the shutdown. This would have a small negative effect on growth in the first quarter. But with the economy expected to grow at a sold pace between 2-21/2% in Q1, the economy is strong enough to weather the small hit (for more details see TD Economics' report).
On the debt ceiling, markets have also seen showdowns that come down to the wire. Most recently, the debt ceiling standoff in 2011 led to a ratings downgrade for the U.S. government, and significant market turmoil. This is less of a risk this time as the U.S.'s credit rating was recently reaffirmed as stable. There were also debt ceiling showdowns in 2013 and 2015 that were shrugged off by markets. Investors have since found out that contingency plans made during the 2011 debt ceiling debacle allowed for interest and principal payments on Treasuries to still be made, while "other" payments would be delayed, avoiding a damaging technical default.
Finally, mid-term elections are approaching. Neither party will want to take the blame for either bringing the government to the brink of default, or a disruptive government shutdown. There may be some political fireworks, which could add to market volatility in the short run, but a deal is likely to get done before it poses a risk to the broader economy.