How the government shutdown will affect interest rates

Market Realist

Shutdown analysis: REITs and homebuilders (Part 2 of 4)

(Continued from Part 1)

Bonds fell slightly and equities rallied on the shutdown. Why?

Beltway insiders who were hoping that the financial markets would get the attention of politicians posturing in Washington were disappointed this morning with the S&P 500 futures up 7 points pre-open and a sanguine outlook from the bond market. Stocks rallied throughout the day, with the S&P 500 closing up 13 points. The yield on the ten-year increased by 4 basis points, but given the volatility of the past few months, that’s quite a tame move. The government shut down, and the market yawned.

It’s all about the Fed

To understand the reaction of the bond market, it’s important to remember why the bond market sold off in the first place. Did the government bond market sell off because the economy began to expand with such force that investors were selling risk-free assets to take more risk? The answer to that question is no. Credit is still tight by most standards—although it is easing—and the economic data so far has been tepid. If economic growth were starting to take off, we would be seeing 400,000 jobs being created a month, retail sales growth in the low double digits, and 1.5 million housing starts. We’re seeing none of that.

The reason why rates backed up was because the Fed said it planned on ending asset purchases (or quantitative easing). The Fed has been buying $85 billion worth of Treasuries and mortgage-backed securities in the secondary market. The fear was that once the Fed pulls back from purchases, asset prices would fall. This became a self-fulfilling prophecy.

The market’s reaction

The market was surprised that the Fed decided not to reduce asset purchases at the September FOMC meeting. Immediately afterward, St. Louis Fed President James Bullard hinted that the Fed could actually move at the October meeting. This shutdown takes that possibility off the table. If the Fed was worried enough about the economic data prior to the shutdown, there just won’t be enough data to change its mind. In fact, we won’t get much in the way of data as all, as some of the agencies like Commerce and Census aren’t releasing economic data while the government is shut down.

A government shutdown of any length would be bearish for the economy. The effect will depend on the duration of the shutdown, obviously. So estimates are all over the board. Suffice it to say that a shutdown of a couple days won’t make much of a difference and a shutdown of several weeks could lop 0.5 points to 1.5 points off of fourth quarter GDP.

So, the reasons the markets yawned at the shutdown were:

  1. We’ve seen this movie before
  2. The shutdown takes October tapering off the table
  3. It won’t help the economy—if anything, it will hurt the economy, which is bond bullish and keeps rates low, and which the stock market indices love

Don’t forget that the big index names have a lot of international exposure, so they’re insulated somewhat from the US domestic economy. Mortgage REITs like Annaly (NLY), American Capital Agency (AGNC), Capstead (CMO), MFA Financial (MFA), and Redwood Trust (RWT) rallied today because the Fed’s support of mortgage-backed securities will continue a while longer (although the shutdown can cut both ways for them).

Continue to Part 3

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