Budget Fight May Freak Out Markets

Whether the federal government “closes down” for this weekend remains unknown at this time.

But for the sake of discussion, let’s assume that Congress fails to agree on a Continuing Resolution for Appropriations for FY 11.  Non-essential personnel in the government will then take the weekend off, waiting to see if they can return Monday or wait a few more days.  The Washington Monument will close during the weekend, but for the most part a week-end shutdown presents no major economic or policy complications.

That’s the general feeling of many in Congress and in the rest of the country.  Shut it down, nobody will notice, and we will have made our point.

Let’s imagine another scenario:

Some people will notice that the American Congress didn’t pass the bill.  They won’t understand what point was made nor why.

Let’s call these people bond traders who work for major financial institutions globally.

Imagine you’re a 31-year-old bond trader in Tokyo, responsible for a small portfolio of $7-10 billion.  Your understanding of the American political system comes only from the books you read and the American traders with whom you do business.  Your American friends tell you, “Don’t worry, they will pass this bill and things will turn out all right.”

But, what happens to the value of your portfolio as Congress dithers?  Will traders at other firms get nervous and begin to sell their positions?  If they do, should you try to beat them out the door by selling first?  If you are caught as the last one out, losing 5-10 per cent of the value of your holdings, you will lose your job.

So, you begin to sell, reducing your risk.  Other traders in the Far East note what they sense is the beginning of a selling trend.  They begin to protect themselves by selling their American bond holdings.  By the time London markets open, computer models at financial firms are flashing a “sell” sign.  Bond traders in London hedge their bets, selling or buying insurance against loss.

By the time New York markets open, and most Americans are awakening, sophisticated computer models all over the globe are signaling “sell.”

Overnight, the 10-year United States note dives in value, with yield going from 3.4% to 4.4%, an almost historic move in 24 hours for the world’s largest debtor nation.

Central banks throughout the world begin to buy as many bonds as they can.  They try to “intervene” in order to stabilize both the fixed income and currency markets.  Lending dries up globally as risk of non-payment rises to unprecedented heights.

Now, that’s just a scenario.  It’s similar to a scenario that in a very minor form played out in the 1990s and ended in the bankruptcy of Long Term Capital Management, a hedge fund.  That bankruptcy threatened a major disruption in markets resulted in a major intervention.

Will bond traders react that way to a short-term American government shutdown this weekend?  Probably not.  The numbers involved are trivial and the world remains a dangerous and unstable place.  So, most investors still seek the “safe haven” of the American Treasury market.

Don’t forget though that this FY11 budget battle is a rehearsal for other really important debates that will happen later this year.

Our 31-year-old Tokyo bond trader will remember the unfathomable behavior of America’s Congress in the FY11 Continuing Resolution matter.  He will become a little leery about risks to his portfolio.

And, when the federal debt ceiling is reached in May or June, and our bond trader sees what he thinks is the beginning of another round of irresponsibility on the part of Congress, he will be wired to sell at the first hint of indecision on the debt ceiling increase.  He will believe that he has seen this movie before.  And, he doesn’t want any part of it.

Markets are driven by psychology as much as any other factor—fear and greed.

When fear overcomes greed, market participants run for the exits, the Devil take the hindmost.

If such a scenario plays out in real life, the result could make the Great Recession of the last three years look minor in comparison.  Perhaps Congress will forget what happened when the House killed TARP the first time through—markets plunged disastrously within minutes.  Markets recovered when the House said, “Oops, never mind” and passed TARP.

So, is a shutdown of the government this weekend really a matter of great concern?

Only to the bond market that trades trillions of dollars of debt each week, and in whose tender embrace the American economy more and more entrusts itself.  Those markets are getting nervous.  They may soon get very nervous.

As James Carville once famously said, “When I die and come back to earth, I hope I come back as a damned bond trader.”

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