Market and economic implications of a government shutdown

Executive Summary

• A government shutdown is looming on March 14^th if Congress is unable to pass the appropriations bills that fund government operations for the remainder of the year.
• We expect minimal economic impact, barring a prolonged shutdown.
• Government shutdowns tend to be high profile though low-impact equity market events. In the previous 20 shutdowns, there has been almost no change on average for the equity market, while it has been in positive territory 50% of the time.
• For fixed income, U.S. Treasury yields have risen modestly, on average during prior shutdowns and typically decline the week after a resolution.
• There is some risk that Moody’s will downgrade the U.S. credit to Aa1 with a looming government shutdown, especially if it is a prolonged one.
• In our view, a credit downgrade wouldn’t be a game changer for the U.S. as there are already two rating agencies below AAA and the U.S. Treasury market remains the largest and most liquid sovereign debt market in the world. While it would be a chink in the armor, U.S. Treasuries should remain the preeminent global benchmark security.

Overall, a government shutdown does not change our overall economic and market view but comes at an inopportune time given choppy markets and mixed economic trend.

Our take & Q&As

What does a government shutdown mean for the economy?

Prior government shutdowns have had very little lasting economic impact. Instead, it tends to mimic a hurricane or snowstorm, delaying most activity and quickly making up for it upon reopening.

Each week of a government shutdown shaves off roughly 0.2 percentage points from annualized gross domestic product (GDP) primarily from the loss of income for approximately 850,000 out of 2.1 million federal workers being furloughed. (The U.S. Postal Service, which isn’t funded by Congress, wouldn’t be affected.) But those workers will be paid retroactively once the shutdown is resolved; thus, GDP should get boosted by a similar amount in the subsequent weeks and months.

Hourly federal contract workers, who generally don’t get retroactive pay for hours not worked, would permanently lose that income, which is estimated at $2 billion per day. There would be a similar permanent loss of income for private-sector workers dependent on federal workers, especially service providers. For instance, the restaurant server or hairdresser down the road would likely see reduced tips or bookings, which don’t get recovered (e.g., you don’t get your hair cut twice the next time).

A shutdown would also delay most economic data compiled by the government – everything from GDP and retail sales to housing and inflation data and unemployment figures – from being released. Essential government workers, including Transportation Security Administration (TSA) officers, will continue to work. Also note that the Federal Reserve doesn’t shutdown as it is funded by industry fees, not the federal government.

How could stocks react to a shutdown?

Government shutdowns tend to inject volatility but typically don’t have major market impact.

• There have been 20 shutdowns since 1976.
• They have averaged 8 days, with the longest one being the most recent at 34 days.
• Stocks have been up 50% of the time during the actual shutdown period and have been flat on average over all periods.

While uncertainty around these events tend to heighten investor angst and add to short-term market volatility, the historical evidence suggests a minimal lasting market impact.

How have bonds done during previous shutdowns?

On average the 10-year yield has risen slightly during government shutdowns, but out of the 20 past shutdowns, 10-year yields were higher only 50% of the time.

After these previous shutdowns have ended, bond yields typically fall with an average 10-year decline of -0.06%. The most recent shutdowns saw yields move only by 0.05-0.10%, whereas in the 70’s and 80’s yields moved by sometimes over 0.50% increments.

We would expect somewhere in between as we have seen yields swing more rapidly in the past couple years as the Fed is still decreasing their balance sheet (QT) and thus liquidity in the Treasury market is lower than it was during the pandemic.

Will this affect the credit rating of the U.S.?

There is some risk that Moody’s will downgrade the U.S. credit rating to Aa1 from Aaa with a looming government shutdown, especially if it is a prolonged one. They put the U.S. on negative outlook in 2011 around the time that S&P downgraded the U.S. to AA+. The reasoning for a potential ratings shift by Moody’s is the political uncertainty created from both the debt ceiling stand-off later this year and the potential shutdown. Their concern is the government’s future capacity to make hard decisions to narrow the country’s deficits, and how political uncertainty may hinder that ability.

There were two very different responses from the Treasury market in 2011 versus 2023.

• Before and after S&P downgraded the U.S. in 2011, the 10-year yield declined, mostly from a “risk off” trade.
• Yet, in 2023 the 10-year yield moved higher before and after the Fitch downgrade.

A sample size of two isn’t large enough to get a definitive read on how a Moody’s downgrade would affect interest rates, but the common theme for both events was that the trend of interest rates before the downgrade probably matters more than the potential downgrade.

Other issuers in the U.S. may be affected as the U.S. sovereign rating influences some corporate and municipal borrowers’ ratings. If other downgrades eventually happen because of the U.S., then issuers may face higher borrowing costs because markets typically demand a greater spread to Treasuries for lower rated issuers.

That said, in our view, a downgrade would not be a game changer for the U.S. as there are already two rating agencies below AAA and the U.S. Treasury market remains the largest and most liquid sovereign debt market in the world. It would be a chink in the armor but ultimately U.S. Treasuries should remain the preeminent global benchmark security.

Are U.S. Treasury securities still safe?

Yes, a government shutdown doesn’t impact the Treasury’s ability to issue new and pay existing bonds. The Treasury has ample funds available to service the national debt. Unlike the debt ceiling problem that Congress will face later this year, Treasuries are not at risk of a delayed payment during a government shutdown.