Shutdown? Default?

BarroMetrics Views: Shutdown? Default?

Let me first congratulate the US team for winning the America’s Cup after being 1-8 down. That is some victory!

Turning to the picture in Washington……Sentimentrader did a study of the effects on the stock market in previous shutdowns. There were 17 such occurrences ranging from 9/30/1976 to 12/15/95. For me, the results were close enough to random. This means there is no reliable pattern of behaviour and the results are dependent on the facts of each case.

In this case, I’d see a shutdown lasting more than a week as having bearish implications for the stock market. The shortest shutdown in the Sentimentrader study was 1 day (4 from 17) and the longest 21 days (1 from 17). I could find no correlation between the shutdown period and the effects on the stock market. The most bearish effects came from shutdowns lasting 8 to 17 days but these were clustered around the same periods (1977 to 1979). Earlier shutdown of the same length had mixed results.

I also had a look at previous debt defaults.  In all there have been 5 occurrences, 1779, 1782, 1862, 1934, and 1979.  I was unable to discover the effects of the first three. In 1933, the total debt on Liberty Bonds (issued to finance WWW I) and other obligations was US$22B. But treasury had only US$4.2B in gold. There was no way treasury could meet just the interest payments in gold, let alone the principal.

Roosevelt defaulted on the domestic debt and devalued the US$ by 40% i.e. defaulted by 40% on its foreign obligations.

Interestingly there stock market  had up year in 1933 and a flat year in 1934. So, you could say, default had little impact.

The  default of 1979 was a technical one only – the treasury defaulted on a small number of bills in the 1979 debt crisis. It eventually paid the face value of the bills and settled the class-action suit by paying the additional interest on the delay. (Claire G. Burton v US). There was no effect on the stock market.

Will there be a default this time?  The Ludwig von Mises Institute suggests there will be no ‘real’ default. In a Short History of US Credit Defaults, it suggests the FED will buy all that is needed to fund the US debt to investors. The FED will then default on these debts. Of course, this means the US taxpayer will bear the brunt either through inflation or by other means.

The key question will be whether a default will signal the Black Swan event in the current context given that the prevailing sentiment -‘something will happen’ in time to solve the problem. We’ll see.

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