Over the weekend talks between John Boehner and President Obama to lift the debt ceiling broke down. As a result the focus has now shifted to a range of negotiations in the Senate. Indeed, Democrats in the Senate have rejected a proposal by Republican Senator Susan Collins to extend the US borrowing authority through January and re-open the government through March, as the proposal did nothing to undo the sequesters, something that is on the wish list of most Democrats. Also, a bill to extend the debt ceiling until the end of 2014 fell short of acquiring the 60 votes that were needed to start debate on it, as no Republican Senators voted in favour of the bill. Consequently, attention has shifted to discussions between Senate Majority Leader Harry Reid and Minority Leader McConnell. Although the outlines of the compromise have remained vague, Harry Reid stated that the talks should be seen ´as something very positive´. Although any Senate deal would need to be approved by the House of Representatives, we continue to think that the debt ceiling will be raised, albeit only at the eleventh hour.
As the federal government remained closed last week due to the fiscal impasse, there were only few data releases. What is more, there were some signs that the shutdown was starting to have an effect on the economy. Indeed, initial jobless claims unexpectedly rose by 66K to 374K in the week ending October 5. Granted, about half of the rise could be explained by a backlog of claims created by computer issues in California last month, but about 15K claims were related to the government shutdown. Although claims filed by furloughed government workers do not show up in the headlines, workers outside the federal government who are affected by the shutdown are being counted. Meanwhile, the preliminary October reading of the University of Michigan Consumer Sentiment index fell from 77.5 to 75.2. We have estimated that a three week government shutdown would shave about 0.5 percentage points off quarterly GDP growth in the fourth quarter, making it difficult for the economy to show any meaningful acceleration in that quarter.
The minutes of the September meeting, in which the Fed, against expectations, decided not to scale back its asset purchase programmes, painted a picture of FOMC members that were torn between competing considerations. On the one hand, members thought that the recovery was not yet strong enough, and that a reduction in the amount of purchases could trigger another tightening of financial conditions. Furthermore, they feared that risks surrounding fiscal policy could hurt the growth outlook. On the other hand, as financial markets had generally expected the Fed to take a first step, members expressed concern that not scaling back the Fed’s QE programmes could hurt the effectiveness of its future communication. Taking everything into consideration, we think that the minutes were a bit less dovish than expected. Indeed, in our view a slight improvement in the data would prompt members to start to taper in December, though an ongoing fiscal impasse could prompt the Fed to err on the site of caution an wait until March.
It was a bad week for US Treasuries. In the beginning of the week, yields moves broadly sideways as lack of progress to lift the debt ceiling spurred safe haven demand. However in the second part of the week, yields started to rise. This reflected the nomination of Janet Yellen to become the next Fed chairman, the release of the Fed’s September meeting minutes, which were somewhat less dovish than what was anticipated, and, most importantly, signs of a deal that would see the debt ceiling being temporarily raised. All in all, yields rose by 3bp to 2.68%. Looking further down the road, we see yields rising to 3% by year end, as we expect that a relatively quick resolution of the fiscal mess will allow the economy to accelerate in the fourth quarter. However, risks are rising that the government shutdown will drag on for longer, which could prompt the Fed to postpone its tapering decision to March next year. Still, once the fiscal issues are cleared, the economy should pick up momentum. As such, our long-term outlook of rising yields in 2014 on the back of a stronger recovery and the Fed reducing its stimulus has not changed.