Buy stocks on Republican lunacy?

Courtesy of FTAlphaville comes a neat note from BofAML on the US government shutdown:

…we would expect only a modest decline in rates (5-10bn on 10y) and a small widening in spreads (7y-10y). The rally is likely to be caused more by the market extrapolating the inability to get a CR deal to a messy debt ceiling process than by the economic effects.

During the 1995 government shutdown, Treasury rates declined and the curve steepened (Table 2). However, in December 1995 and January 1996 the Fed eased an unexpected 25bp for the first time after the 1994-95 hiking cycle. This can explain much of the rate and curve move at that time. Interestingly, there was no negative reaction by the stock market. Note that a government shut down occurred twice in this period and the second shutdown was relatively long.

…Some concerns from CDS market
The US Sovereign CDS curve inverted for the first time, with 1y CDS spreads trading nearly 20bp higher than 5y CDS spreads. Although not a very liquid product, this appeared to be the market pricing in small probability of a postponed payment.

And the key dates:

October 15
We estimate that the Treasury exhausts its accounting maneuvers on October 15. This date is the settlement of the mid-month coupon auctions, in the 3y, 10y, and 30y maturities. Any uncertainty in the ability to settle the entire auction without breaching the debt limit would require one of three choices: delaying the auctions and issuing cash management bills instead. scaling down the auction sizes to only roll over maturing issues, or auctioning the full amount and scaling down the regular bill sizes ahead of time to create enough headroom, with the last alternative being the most likely in our view. According to our estimates, this date would be a fairly close call, but maneuvers are certain to be exhausted in the next day or so, with a mid-October payment into the Highway Trust Fund. After this date the Treasury would be in rollover mode, issuing just enough at each auction to roll over maturing debt, while paying for outlays using withholding tax revenues and steadily draining the outstanding cash balance. In our view the Treasury may have enough cash balance to make it to the end of the month and make the month-end interest payment, although there is substantial uncertainty.

November 1
Treasury will fail on its scheduled spending obligations on November 1, having almost certainly exhausted its cash balance. A total of $67bn in payments in social security, Medicare, Medicaid, military pay and veterans programs will be due on this date. After this, the Treasury could only spend money as it comes in via tax revenues, with scheduled payments being delayed or only paid partially. It is uncertain how the Treasury will prioritize spending programs.

November 15
The first large coupon interest payment of $31bn is paid on November 15. If the debt limit is not raised by then, the Treasury is likely to fail to pay bond interest and will be in technical default.

Zero Hedge adds from the same note:

The shutdown will likely add to the budget deficit. It is costly to stop and start programs. The 1995-96 shutdown directly added $1.4 bn to the deficit (about $2.5 bn in today’s dollars) Moreover, the shock to growth will undercut tax revenues. In addition, ironically it does not impact the implementation of Obamacare since it is an entitlement similar to Medicare. However, there is some chance it could delay US economic data releases: in 1996, the December employment report was delayed two weeks as a result of the shutdown then. The Federal Reserve and the Post Office, both of which do not depend on Congressional appropriations, will not see any cutbacks due to a shutdown.

…Should we have a shutdown, we would expect it would be relatively short — public uproar and market pressure will hopefully spark an agreement. A shutdown of a few days would likely have no real measurable effect upon the economy and result in only a small sell-off in the markets. Most of the federal government will keep running in the event of a shutdown, but a significant number of federal employees will be furloughed without pay, perhaps as many as one million. The impact on 4Q GDP growth should rise with the length of the shutdown: a coupleday shutdown would likely have zero net impact upon growth; a two-week shutdown could shave 0.5pp, while a one-month shutdown could lop 2pp from 4Q growth. These are, of course, rough estimates and subject to big standard errors.

The key source of uncertainty is the impact on consumer and business confidence. The revised GDP data showed very weak growth in 4Q 2012 and 1Q 2013 around the fiscal cliff negotiations, which in large part reflects heightened uncertainty. This time around, the hit to confidence and the markets could be larger still if a protracted shutdown signals the potential for an unmanaged process after the debt ceiling is breached. Lingering uncertainty — let alone a fiscal accident — would raise the chances that the Fed does not taper until next year.

Paul Krugman reckons:

If the feds are forced to slash spending, one way or another (and probably semi-randomly) to match receipts, that’s about $600 billion in cuts at an annual rate, or 4 percent of GDP. That’s a huge case of unintended austerity, quite aside from the disruptions, surely enough to push us back into recession if it lasts for any length of time. And a double-dip recession would, in turn, push back the date of Fed rate increases far into the future, which would normally cause a big drop in long-term rates. So I’m not at all sure that we’re looking at an interest rate spike; maybe even the opposite. But for sure we should be looking at a plunging dollar, and probably carnage in the stock market too.

Bit of grandstanding there. I still don’t think the Republicans are stupid enough to take this very far. As one reader put it nicely yesterday, they’ll placate the base then back off.

Last night’s action was a long way from panic-stricken with stocks down 1% but bonds stable. The Australian dollar rallied too so there’s no real “risk off” move here yet. That raises the prospect that the sell-off is a buying opportunity. I’d say so, but only for traders operating on short term gains. I’m already on the record saying this is no time to be long. Beyond the politics, the taper-talk will go on even though the window has been missed. Though if the political arm-wrestle results in new spending cuts the Fed could extend its purchases by six months which would boost any post-politics relief rally. But with China’s rebound at roughly 7.5% growth as good as it’s going to get and with Europe’s fiscal teutons sharpening their blades post German election, the little cycle of growth upgrades has likely run its course.