STRATEGIES

So far, the US government shutdown, and similar political deadlock in Italy, hasn't rattled the market. Here's a look at how much calm we can expect before the storm, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

So Where's the Panic?

The US government has shut down, with formula to end the crisis short of interventions by the ghosts of George Washington and Abe Lincoln.

Next, in two or three weeks, the United States government will hit its debt ceiling limit and nobody is negotiating with anybody to avoid a confrontation with just two likely outcomes:

  • Option 1 is a default on US government debt that could send global financial markets into chaos;

  • and Option 2 is a US constitutional crisis if President Barack Obama decides to ignore the debt ceiling.

Meanwhile, the Italian coalition government looks likely to fall and the country is likely to, Number 1, violate its promise to reduce its budget deficit this year to 3% or less and, Number 2, continue in a recession that now stretches back to 2011.

And the reaction to this turmoil in the financial markets? On Monday morning, in the first hours of a New York trading session that was the first time that US financial institutions and traders could react to the weekend's news, the yield on the US 10-year Treasury actually fell—meaning that the bond rose in price—by 0.01 percentage point to 2.61% as of 9:30 AM, New York time.

And while stocks were down 2.06% in Tokyo overnight, as the trading day moved towards the source of news in Rome and New York, the damage got progressively smaller. Stocks in Milan were down just 1.33% as the trading day there moved toward a close on Monday. And at Monday's close in New York, the Standard & Poor's 500 was off 0.6%.

That's panic? Nah, that's ho hum.

So why are the markets acting so blasé? How long might that collective shrug last? And what's going on under the surface that might suggest a deeper anxiety?

Washington, take some time off

First, the markets don't think that a shutdown of the US government is a very big deal. Everyone understands that a shutdown will leave much of the government operating—Social Security checks will go out and air traffic controllers will work without pay. As long as the shutdown is of limited duration—a couple of weeks at the outside—no big deal.

Second, perverse as it may be, bond traders see a limited shutdown of the US government as a plus for US Treasurys. The theory is that a government shutdown and the resulting reduction in US economic growth pushes off the day when the Federal Reserve will begin to taper off its $85 billion in monthly purchases of Treasurys and mortgage-backed assets. A short shutdown would take the possibility of an October decision to begin a taper off the table and might even push a December taper toward the realm of the unlikely. From this perspective, the recent rally in US Treasurys that has taken the yield on the 10-year Treasury down to 2.59% is a continuation of the post-September 18 rally in Treasurys, when the Fed didn't take action on a taper.

Third, there's still a large element of denial. More traders seem to believe that whatever bad does happen won't be in effect for very long. At an extreme, the markets want to deny that the Republican leadership in the House of Representatives won't decide to let Democrats and a few Republicans pass a clean continuing resolution, or that Italian Prime Minister Enrico Letta won't be able to put together the votes to win a confidence vote in the next few days or that.

(Some background on this less familiar confrontation: Over the weekend, in Italy, the government of Prime Minister Letta moved to the edge of collapse after allies of Silvio Berlusconi said they planned to quit the coalition government. Berlusconi's conviction on a criminal charge of tax fraud leaves him open to expulsion from parliament, and Letta has refused to block those proceedings. So far, Italian president Giorgio Napolitano hasn't dissolved parliament or called for new elections, but that seems just a matter of days with Letta saying he plans a confidence vote in parliament on October 1 or 2. Letta's government would probably lose that vote without the support of Berlusconi's People of Liberty party. Yields on Italy's 10-year bond were up 0.13 percentage points last week to 4.42%.)

And, fourth, institutional investors calculate that as long as the turmoil in Washington and Rome doesn't get too intense, or go on for too long, it's cheaper to hedge bets with derivatives such as credit default swaps on US or Italian debt than to actually liquidate positions. No need to actually sell Treasurys or US stocks if insurance in the derivatives market stays cheap enough.

If those are the reasons for the market's very muted reaction to the current news coming out of Rome and Washington, DC, then I get this framework for projecting how markets will react going forward.