On Oct. 1, the start of the fiscal year, the U.S. government entered a partial shutdown due to the failure to renew the spending authority (the budget), which is a separate issue from the borrowing authority (the debt ceiling). The disagreement in Congress centers on provisions in the spending bill to defund or delay the Affordable Care Act (also referred to as Obamacare). As a result of the shutdown, some 800,000 federal workers have been furloughed and many non-essential government services and departments have been closed.
The economic impact will depend on how long the standoff lasts. The economic data suggest that Q3 growth was a lot lower than anticipated and so the crisis in Washington arrives at a particularly bad time. Stocks haven't fallen too far, however. The S&P 500 lost only 0.07 percent in the first five trading days since the shutdown and the NASDAQ actually rose 0.69 percent, marking its fifth straight weekly advance. The CBOE VIX, unsurprisingly, rose 9.25 percent last week with still no resolution to the budget impasse at the end of the week. Based on historical precedents, the shutdown will probably subtract an annualized 0.5 percent off Q4 growth if it lasts for another two weeks.
While the shutdown makes headlines, the issue that will have the most impact on the economy and financial markets is the debt ceiling. U.S. law dictates that the Treasury is only allowed to issue debt up to a specific amount. The current limit of $16.699 trillion has already been reached and negotiations are currently taking place to give more breathing room. A default on government debt would set off a chain reaction in the global fixed income markets. Financial firms have no way of dealing with Treasury securities in default. Already, the threat of default has led to some weakening in the dollar and a spike in four-week Treasury bill yields (reflecting some probability that these bills will not be paid off in time). IMF managing director Christine Lagarde has cautioned that U.S. GDP could slip below two percent this year if the debt ceiling is not raised.
The budget and debt crisis together will likely put tapering QE off the table for 2013. The Treasury has said the U.S. will exhaust its borrowing authority by Oct. 17, 2013, with the first interest payment due on Oct. 31. Though chances of a default are slim, the repercussions if it happens could be catastrophic and put a serious dent in the already fragile U.S. economic recovery.