Markets watch as US government faces shutdown

<p>Deadlock on Capitol Hill over talks to agree government spending for the next year saw investors sell out of risk on Monday, as the midnight […]</p>

Deadlock on Capitol Hill over talks to agree government spending for the next year saw investors sell out of risk on Monday, as the midnight deadline loomed where a failure to reach an agreement would effectively shut down the US government.

Stock markets across the world fell as traders sat with trepidation over the results of last minute talks between Republicans and Democrats this evening. The FTSE 100 fell 50pts going into the close, whilst US stocks opened down 0.6% and Asian stocks fell overnight to the tune of at least 1.5%.

The US dollar dropped to its lowest levels since February whilst the sterling/dollar exchange rate hit a new 8 month high of $1.6180.

The Volatility Index or VIX, a key gauge of fear or pessimism in the markets, rose to a one month high and was close to breaking to its highest levels since June. The VIX itself has risen by 19% in the last two trading days alone.

The market reaction is entirely justified given the risks a shut down poses and today’s losses would have been worse were it not for the fact this is not the first time markets have had to watch political game playing on Capitol Hill threaten investor confidence. Investors today are battle hardened and so with there being multiple examples in the recent past of last minute deals being made between Republicans and Democrats, investors have been happy to take some risk off the table but wait until there is evidence that a complete shut down cannot be avoided before fully fleeing risk.

There remain faint hopes that a short term funding agreement can be put in place to buy time for bi-partisan talks and avoid a government shut down. I suspect a short term agreement may be the most likely scenario, even if the government is forced to temporarily shut down this week.

The big fish however is the US debt ceiling negotiations and that is the key reason why both parties are refusing to give any ground in talks now to avoid a shut down. Any sign of weakness is likely to be seized upon by the other side and this is why both parties are showing strong hands right now. A shut down of the US government – a likely temporary one if that – would not have a significant impact on the US economy. However, failure to raise the debt ceiling will do. So these budget talks are merely the starter.

That said, a shut down in US government will likely bring a volatile edge to trading this week, particularly with US jobs data due out on Friday which will be the markets first chance to gauge US jobs data after the Fed’s no taper decision last month.

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