How The Battle In Congress Is Making Markets Less Volatile

by Business Insider | October 4, 2013 1:09 pm

One might think that all of the battling in Congress over passing a continuing resolution to fund the government and raising the debt ceiling would increase volatility in financial markets.

After all, the political brinksmanship has already resulted in a partial shutdown of the U.S. government, and now investors are “thinking the unthinkable”[1] when it comes to the debt ceiling, which needs to be raised in a few weeks or the U.S. will be forced into technical default on its debt.

BofA Merrill Lynch interest rate strategist Ruslan Bibkov argues that the dysfunction in Washington is actually having the effect of making markets less volatile, for two reasons: (1) it increases the odds that the Federal Reserve will refrain from tapering back its quantitative easing program anytime soon; and (2) the blackout on government-released economic data during the shutdown is removing some of the biggest catalysts for volatility from the market.

In a note to clients, Bibkov writes:

Although a short-term government shutdown is unlikely to have any measurable economic consequences, a prolonged shutdown should have a negative effect on GDP. Our economics team estimates that a two-week shutdown can erase as much as 0.5% of GDP growth. As a result, continuing brinkmanship increases the odds of a delayed Fed tapering and therefore should be negative for volatility, especially in the upper-left part of the vol surface. What’s more, with BLS and BEA closed we are set to have a smaller inflow of data in the coming days. In particular, September payroll report is most likely to be delayed. We therefore expect realized volatility to be low in the near term and recommend selling gamma going into next week.

If Congress actually fails to raise the debt ceiling, however, Bibkov says it’s a different story — but not before then:

Treasury default should bring higher vol

The debt ceiling impasse is a greater risk to the vol market, given some chance of a missed payment by the US Treasury. We expect a severe risk-aversion shock in a scenario where a missed payment occurs accompanied by a dramatic increase in market volatility given unprecedented nature of such an event and its disruptive effect on the functioning of financial market.

But expect low vol before the drop-dead date

At the same time, we do not expect a significant rise in volatilities before the drop- dead date. At this point the market is used to last-minute deals from Washington, while far-reaching consequences of the Treasury default are likely to convince most investors a default will not occur. In fact, even during 2011 debt ceiling impasse episode volatilities did not richen going into the drop-dead date of August 2, even though the agreement was reached only on August 1 (Chart 11). Although volatilities eventually increased later in August, this was triggered by S&P downgrade of the US sovereign rating and escalation of the debt crisis in peripheral Europe rather than the debt ceiling impasse itself.

 

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Endnotes:
  1. investors are “thinking the unthinkable”: http://www.businessinsider.com/global-weekly-fund-flows-october-2-2013-10?utm_source=investorplace&utm_medium=referral
  2. MORGAN STANLEY: ‘The Government Of The United States Is Not Going To Default’: http://www.businessinsider.com/morgan-stanley-us-default-last-resort-2013-10?utm_source=investorplace&utm_medium=referral
  3. GOLDMAN: Here’s What Happens When The Government Shutdown Meets The Debt Ceiling: http://www.businessinsider.com/government-shutdown-meets-debt-ceiling-2013-10?utm_source=investorplace&utm_medium=referral
  4. MORGAN STANLEY: Now That The Government Has Shut Down, Here Are 4 Things To Expect: http://www.businessinsider.com/government-shutdown-2013-10?utm_source=investorplace&utm_medium=referral

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