The US government could shut down this weekend — and we're not ready

REUTERS/Kevin Lamarque

• There's a 50/50 chance that Democrats and Republicans can agree on a budget and avoid a government shutdown after midnight Friday. 
• It’s very difficult to imagine that the Federal Reserve would go forward with its planned interest rate hike on December 13 if the government shuts down.
• We could see a violent market reaction if the Fed stays put and doesn’t raise rates.

Will Republicans and Democrats agree on a budget, and avoid a government shutdown after midnight Friday?

I’d say the odds are 50/50. Actually, I put the odds of a shutdown at about 55%. There’s certainly enough substance here to be wary.

The government could shut down because of disagreements over defense spending, funding for Trump’s wall with Mexico, deportation of illegal immigrants brought to the U.S. as children (the “Dreamer Act” also referred to as “DACA”), funding for Planned Parenthood, funding for Obamacare (called “SCHIP”), disaster relief and more.

There’s not much middle ground between Democrats and Republicans on many of these hot button issues.

How would a shutdown affect the Fed’s plans to raise rates on the 13th?

If an agreement can’t be reached and the government does shut down, it’s very difficult to imagine that the Fed would go forward with its planned interest rate hike on Dec 13.

Meanwhile, markets are almost certain the Fed will raise rates. It’s already “baked into the cake.”

The euro, yen, gold and Treasury notes are all fully priced for rate hike. If it happens, those instruments won’t change much because the event is priced.

But we could see a violent market reaction if Janet Yellen stays put and doesn’t raise rates.

If the Fed doesn’t raise rates, gold could soar as the Fed passes on its best chance to raise rates and markets perceive that easy money is here to stay. Euros, yen and Treasury notes will also soar.

Of course, saying the government could shut down is different than saying the government will shut down. Again, I give it about a 55% chance at this point.

And there are lots of ways for things to go wrong.

Late last week the Commerce Department released the October PCE core inflation data. This is important because that’s the number the Fed watches. There are plenty of other inflation readings out there (CPI, PPI, core, non-core, trimmed mean, etc), but PCE Core year-over-year is the one the Fed uses to benchmark their performance in terms of their inflation goal.

The Fed’s target for PCE Core is 2%. The October reading was 1.4%. For weeks I’d been saying that a 1.3% reading would put the rate hike on hold, and a 1.6% reading would make the rate hike a done deal. So, the actual reading of 1.4% was in the mushy middle of that easy-to-forecast range.

What’s interesting is that the prior month was also 1.4%, so the new number is unchanged from September. That’s not what the Fed wants to see. They want to see progress toward their 2% goal.

On the other hand, the 1.4% from September was a revised number. It was earlier reported at 1.3% (the same number as August).

You can read this two ways. If you see the August 1.3% as a low, then you can say the 1.4% readings for September and October were progress toward the Fed’s 2% target. It’s a thin reed, but Yellen could use this to justify her view that the year-long weakness in PCE Core is “transitory.”

On the other hand, these 0.1% moves month-to-month are really statistical noise and may even be due to rounding. The bigger picture is that PCE Core is weak and nowhere near the Fed’s target. Another rate hike in December could be a huge blunder if it slows the economy further and leads to more weakness in PCE Core.

On balance, the PCE Core number is probably just enough (barely) to justify a rate hike. I’ve raised my probability of a December rate hike from 30% to just over 50% — 55%. That’s what analysts are supposed to do; they update forecasts continually based on new data. You can’t be stubborn about your analysis.

I’m not trying to be “in consensus” or “out-of-consensus.” I just want to get it right, and that means sometimes I’ll be in consensus. Other times, I won’t be.

But you should forget how the market is pricing the outcome. The Fed funds futures market has been off by orders of magnitude before. In mid-February 2017, the futures markets gave the odds of a rate hike in March at 30%.

I was giving 80% odds.

Within three trading days at the end of February, the market odds shifted from 30% to 80% before converging at 100% by the March meeting.

That does not mean I’ve got it right this time. But it does illustrate that the futures market does not always get this right — not even close.

And markets are being set up for a fall.

Bull markets in stocks seem unstoppable right up until the moment they stop. Then comes a rapid crash-and-burn phase.

Is there ever any warning that a collapse is about to happen?

Of course there is. Analysts warn about it all the time and provide mountains of data and historical evidence to back up their analysis. The problem is that everyone ignores them.

You can talk about the dangers represented by CAPE ratios, margin levels, computerized trading, persistent low volatility and complacency all you want, but nothing seems to slow down this bull market.

Yet there is one thing that can stop a bull market in its tracks, and that’s corporate earnings.

The simplest form of stock market valuation is to project earnings, apply a multiple and, voilà, you have a valuation. Multiples are already near record highs, so there’s not much room for expansion there.

The only variable left is projected earnings and that’s where Wall Street analysts are having a field day ramping up stock prices. Earnings did grow significantly in 2017 on a year-over-year basis, but that’s mainly because earnings were weak in 2016, so the year-over-year growth was relatively easy.

Now comes the hard part.

How do you expand earnings again in 2018 when 2017 was such a strong year? Wall Street just uses a simple extrapolation and says next year will be like this year, only better! But there is every reason to doubt that extrapolation.

Earnings are likely to fall short of expectations, which can lead to a correction. Once that happens, multiples can shrink as well. Soon you’re in a full-scale bear market with stock prices down 20% or more.

That’s without even considering a war with North Korea and all of the dangers others have already mentioned. This may be your last clear chance to lighten up on listed equity exposure before the bubble bursts.

Markets are creatures of manipulation by Fed policy changes, statements, forward guidance and the other prestidigitation of modern central banks. That’s what you get after 10 years of ZIRP, QE, tapering, QT, forward guidance, currency wars and musings about NIRP.

Shutdown or no shutdown, the Fed has painted itself into a corner and there’s no way to escape the room. That’s the larger story to keep in mind as Dec. 13 approaches.

Tune out the current sideshow and keep that in mind.

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