Today's post comes off the back of Scott Sumner's note in his blog that short-term crises may not only have temporary effects on markets:
"I am very sympathetic to the view that market setbacks in response to short-term crises are temporary. It certainly looks that way. However it’s a dangerously misleading way of looking at markets."
I think Scott is right and I think the complication comes when we stop looking at one-off short term crises and instead start to look at repeating short-term crises, like the current budget rounds. In these latter cases we should expect to see long-term effects on markets up until the budget issues are finally resolved.
I see this effect being based on three factors: (i) market attention to/awareness of the risk (if they can't see it, they can't price it; if they don't care about it, they don't price it); (ii) the probability of the event occurring; and (iii) the magnitude of the event it is does occur.
Turning to (i) first – the market doesn't have an infinite supply of attention, rather like NASA scanning the sky for asteroids, it can only pay attention to a certain percentage of risks at any one time. That means that if a risk isn't immediate, or one that is repeating, the market has a habit of forgetting about it.
This is what happened with the most recent US government shutdown. The last budget round set a clear precedent that this budget round would lead to another crisis that wouldn’t be resolved until the eleventh hour. But budget crises hadn't yet formed a pattern, like those set by Europe last year where there was a continuous market focus on Italian debt auctions, and as a result, the market didn't pay attention to the latest budget round until it was right on top of it.
That is why markets began to slide on 20 September, a full 11 days before any government shutdown would begin, despite being more than aware from past form that resolution shouldn't be expected for at least a week. Markets started to fall because they remembered the budget round was coming, not because probabilities had altered.
The difference going forwards following this latest budget round is that budget crises have now begun to form a pattern. Indeed we know that the next battles are only three months away (one in January and one in February) and that isn't long enough for the market to forget them. This awareness will mean that markets will continue to price budget crises into their models and thus affect pricing until the repeating cycle is broken.
Turning to (ii) – the fact that the last budget round was a crisis does not in and of itself make it any more likely that the next budget round will similarly be a crisis (but it does make the market more aware to them). What matters is how that last crisis ended – was there final resolution or do the terms of the deal leave matters unresolved.
Its uncontroversial to say that the deal struck to end the shutdown wasn't a home-run; it didn’t forbid budget-ransoming in the future, nor did it deal with the issues that made Republicans hold a gun to the head of government. That said I think it's fair to say the will of the Republicans has taken a hit and the next round should be easier (although not all agree).
As a result I don't see the probability of the next budget round ending in crisis as being as great as it was heading into this budget round. However it's not hard to see a situation where Republicans had managed to keep public opinion more on their side and be fired up for January. In that circumstance the market would see a higher probability of budget crises next round coupled with an increase awareness of budget crises.
Together that would mean a long term depression of market expectations until either (i) the probability of crises decreased; or (ii) the cycle was broken.
On (iii) – the magnitude of a US default is something that I don't think the market can price accurately for the simple fact that a global reserve currency doesn’t default that often and so there isn't the data to make an informed estimate. On top of that, we couldn’t calculate what would happen when Lehmans went down so I doubt we can make anything like a fair guess for a US default.
As a result I don't think that the events of the last few weeks have moved the markets view on the magnitude of the crises, if anything I worry that having walked up to the precipice there will be slightly less worry next time (quite wrongly.)
To wrap up – I'm not sure that this budget crisis has put a long term dint into the markets, primarily because the Republicans lost so much political capital. However, through the mechanisms I outlined above I think that repeating short-term crises can cause long term effects and we're just lucky that this one (probably) hasn’t.
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