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Libby Cantrill, Josh Thimons
When we last wrote, in March 2013, we postulated that policy uncertainty in Washington over the short term was on the decline – and for the past few months, that has been the case. There have been no manmade crises or eleventh-hour standoffs, the singular focus on austerity that has characterized the past two years has receded and the operational impact of congressional dysfunction has largely been contained.
Market volatility, likewise, has been spared policy-induced spikes, such as those surrounding last year’s elections (19% in the CBOE VIX Index on 7 Nov. 2012) and the fiscal cliff showdown (22% in the VIX Index on 28 Dec. 2012). Current equity market implied volatility stands just south of 14% (source: VIX as of 16 Aug. 2013), reflecting a rather benign outlook. However, after a welcome reprieve, we expect policy uncertainty to once again increase: This fall, a confluence of fiscal deadlines could weigh on the economy and push market volatility substantially higher.
What’s on tap? Congress is back at it again. Disregarding lessons from previous fiscal fights, each party seems to be digging in and ramping up the rhetoric in advance of several contentious fiscal and economic policy events, including a possible government shutdown, a debt ceiling increase and a probable selection of a new Fed chairman.
Possible government shutdown: Although both chambers of Congress passed a budget this spring (a first in four years), they have not followed up by passing requisite appropriations bills for the upcoming 2014 fiscal year. This means Congress must pass a short-term spending bill to fund the government, known as a continuing resolution, by 30 September to avoid a government shutdown.
Unlike the last continuing resolution, which was passed in late March with little consternation, this time congressional leaders seem to be steeling themselves for a larger fight. Republicans want to fund discretionary government spending at levels stipulated by the sequester cuts and spending cap levels in the Budget Control Act (the 2011 debt ceiling compromise) of $967 billion, while Democrats want to effectively replace the sequester and fund the government at a higher amount of $1.058 trillion, a difference of $91 billion.
Our prognosis? While bluster and posturing will abound, we think that ultimately, a short-term deal to fund the government will be reached and a government shutdown averted, although likely not until the last minute. We think a shutdown will be avoided largely because it would not benefit anyone politically – a fact Speaker John Boehner knows all too well, having experienced the political fallout of the 1995 and 1996 government shutdowns (for which House Republicans were largely blamed). In fact, over the past month, many Republicans, including the influential Rep. Paul Ryan, have indicated that threatening a government shutdown is a losing strategy. Nevertheless, we do not think congressional Democrats will be successful in their efforts to modify the 2014 planned spending cuts, and as such, look for a stopgap deal (likely of a few months) to fund the government at or close to spending levels required by the Budget Control Act. This means government spending will likely continue to be a drag on the economy in 2014.
Debt ceiling increase: Recent data from the U.S. Treasury indicate the current $16.7 trillion government debt limit will need to be increased this fall, likely by November, in order for the government to avoid default. Although the debt ceiling was raised earlier this year without significant drama, this time looks to be different, with Speaker Boehner pushing for a similar debt ceiling deal to the one agreed to in 2011 – effectively a one-for-one cut in federal spending for each dollar increase in the debt ceiling. Meanwhile, President Obama and congressional Democrats have insisted they will not negotiate over a debt ceiling increase.
Our outlook for the debt ceiling is that a resolution will ultimately be reached, but will likely follow the pattern of nearly every other recent fiscal negotiation: demagoguery and brinkmanship up front, followed by a deal cobbled together at the eleventh hour. What that deal might look like is uncertain, although there is speculation that a large, comprehensive deal that includes cuts to entitlement spending and revenue raisers could be in the works. While the public has been enchanted by this talk of a so-called grand bargain before, we think the same obstacles from the past two years remain today: Republicans want cuts to entitlement spending without any tax increases, and Democrats will only agree to entitlement cuts if they involve substantial tax increases.
Federal Reserve chairman nomination: Lastly, since current Fed Chairman Ben Bernanke is expected to step down when his second term is complete in January 2014, the Obama administration will likely nominate a new chairman this fall. There is no specific deadline – only time enough to allow for Senate consideration and confirmation before the end of January.
Speculation abounds over who will be appointed, with the press increasingly framing the debate between Fed Vice Chair Janet Yellen and former Treasury secretary Larry Summers. While PIMCO will not lean in on this debate and is not in the business of endorsing candidates for government positions, we do believe the outcome is significant for the markets.
Until recently, the market was pricing in a Yellen nomination. In many ways, the market sees her as the obvious choice: She would be the least disruptive candidate and would provide the most continuity, since her outlook and approach to monetary policy are well-known. Politically, she gives President Obama, who has been criticized for appointing too few women to leadership posts, the opportunity to nominate the first-ever female Fed chair, breaking a significant glass ceiling. Importantly, Yellen has very impressive academic and professional credentials and is not weighed down with a lot of political baggage, making a Senate confirmation process likely straightforward.
Recent press reports, however, have the market reconsidering these prior assumptions on the likely nomination. What appeared to be trial balloons from the administration regarding Larry Summers, followed by the president defending Summers’ record publicly, have made clear that the debate is far from over, and Summers, who is closer to the president’s inner circle, could in fact be the front-runner.
Gauging the potential market impact depends on how the market characterizes the monetary policy framework of each candidate.
Markets perceive Janet Yellen to be a dovish version of Ben Bernanke. Her “optimal control” model for monetary policy has often appeared to be the driving force behind the Fed’s decisions. In layman’s terms, this model calls for more central bank aggressiveness than that of traditional models to generate employment growth, even if it means accepting higher than the targeted 2% inflation rate for a period of time. Relative to other central bankers, she has demonstrated a willingness to experiment, to rely upon models and to be bold.
Summers, due to a lack of direct monetary policy experience, is much less known to markets. Most investors would also characterize him as a “dove,” but not to the degree of Yellen. While Summers has generally supported the Fed’s accommodative policies, he has been critical at times of the efficacy of quantitative easing. He has often called on fiscal agents to provide more economic heavy lifting rather than depending solely upon monetary policy. Many believe a Summers Fed would be less focused on consensus-building and transparency, which have been hallmarks of the Bernanke (and Yellen)-led Fed.
Investment implications These policy debates have important ramifications for investors and could drive market volatility higher in coming months.
The first two debates, regarding government funding and the debt ceiling, pose challenges to both risk asset valuations and volatility markets. Political rhetoric that threatens to shut down the government or default on government debt is inherently destabilizing. However, in what perhaps is a sad commentary on the state of affairs, the markets now expect very little out of Washington and have become accustomed to politicians taking us to the brink of fiscal catastrophe.
During the fiscal cliff debates at the turn of the year, markets did not react negatively to Congress’ lack of a resolution until the week between Christmas and New Year’s. Thus, the market base case in this next round of fiscal negotiations is for another last-minute, kick-the-can deal, so the risk to markets is more of a tail risk that Congress cannot compromise this time, which would likely lead to sharply lower risk asset valuations and sharply higher implied volatilities. Investors concerned with such a scenario may look to buy downside puts on equity and credit indexes. These hedges currently trade at attractive levels compared with much of the post-crisis era given recent market stability.
While the potential impact of the government spending and debt ceiling debates on markets is more of a one-sided tail risk, the back and forth of the Fed chair debate will likely continue to sway markets over the next few months.
If Yellen becomes the Fed leader, a dovish mistake of staying accommodative for too long is a greater risk than one of withdrawing accommodation prematurely. A Yellen appointment would likely lead to Treasury yields remaining extraordinarily low (or lower), the yield curve remaining steep, TIPS (Treasury Inflation-Protected Securities) outperforming due to risks of future inflation and mortgage credit tightening due to a willingness to engage quantitative easing.
The Fed under Summers would perhaps be more susceptible to a hawkish policy mistake than it would be under Yellen. He is less likely to support the Fed’s balance-sheet-expansionary policies for as long as Yellen would, which would mean relatively higher nominal Treasury yields and mortgage credit spreads, all else equal.
The potential impact on equity markets is more ambiguous. Some believe Yellen’s policies are more supportive of equity valuations, which have relied upon (and possibly are addicted to) extraordinary Fed liquidity provision. By contrast, others believe that Summers’ more optimistic outlook for the economy and likely willingness to “hand off” from public sector support to the private sector is exactly what equity markets are ready for and need for long-run investor confidence.
Regardless of who the ultimate nominee is, we expect the debate will increasingly lead to greater uncertainty and greater market volatility. Added to the potential volatility from the government spending and debt ceiling debates, investors should brace for a bumpy road ahead this fall.
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