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PIMCO: Policy Uncertainty on the Rise

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A possible government shutdown, the debt ceiling increase, and the Federal Reserve chairman nomination -- all events that could push volatility much higher.

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In March 2013, our firm postulated that policy uncertainty in Washington over the short term was on the decline -- and for the past few months, that has been the case. There have been no manmade crises or eleventh-hour standoffs, the singular focus on austerity that has characterized the past two years has receded, and the operational impact of congressional dysfunction has largely been contained.

Market volatility, likewise, has been spared policy-induced spikes, such as those surrounding last year's elections (19% in the CBOE VIX Index (INDEXCBOE:VIX) on November 7, 2012) and the fiscal cliff showdown (22% in the VIX Index on December 28, 2012). Current equity market implied volatility stands just south of 14% (source: VIX as of August 16, 2013), reflecting a rather benign outlook. However, after a welcome reprieve, we expect policy uncertainty to once again increase: This fall, a confluence of fiscal deadlines could weigh on the economy and push market volatility substantially higher.

What's on tap?

Congress is back at it again. Disregarding lessons from previous fiscal fights, each party seems to be digging in and ramping up the rhetoric in advance of several contentious fiscal and economic policy events, including a possible government shutdown, a debt ceiling increase and a probable selection of a new Fed chairman.

Possible government shutdown: Although both chambers of Congress passed a budget this spring (a first in four years), they have not followed up by passing requisite appropriations bills for the upcoming 2014 fiscal year. This means Congress must pass a short-term spending bill to fund the government, known as a continuing resolution, by September 30 to avoid a government shutdown.

Unlike the last continuing resolution, which was passed in late March with little consternation, this time Congressional leaders seem to be steeling themselves for a larger fight. Republicans want to fund discretionary government spending at levels stipulated by the sequester cuts and spending cap levels in the Budget Control Act (the 2011 debt ceiling compromise) of $967 billion, while Democrats want to effectively replace the sequester and fund the government at a higher amount of $1.058 trillion, a difference of $91 billion.

Our prognosis? While bluster and posturing will abound, we think that ultimately, a short-term deal to fund the government will be reached and a government shutdown averted, although likely not until the last minute. We think a shutdown will be avoided largely because it would not benefit anyone politically -- a fact Speaker John Boehner knows all too well, having experienced the political fallout of the 1995 and 1996 government shutdowns (for which House Republicans were largely blamed). In fact, over the past month, many Republicans, including the influential Rep. Paul Ryan, have indicated that threatening a government shutdown is a losing strategy.

Nevertheless, we do not think Congressional Democrats will be successful in their efforts to modify the 2014 planned spending cuts, and as such, look for a stopgap deal (likely of a few months) to fund the government at or close to spending levels required by the Budget Control Act. This means government spending will likely continue to be a drag on the economy in 2014.

Debt ceiling increase: Recent data from the US Treasury indicate the current $16.7 trillion government debt limit will need to be increased this fall, likely by November, in order for the government to avoid default. Although the debt ceiling was raised earlier this year without significant drama, this time looks to be different, with Speaker Boehner pushing for a similar debt ceiling deal to the one agreed to in 2011 – effectively a one-for-one cut in federal spending for each dollar increase in the debt ceiling. Meanwhile, President Obama and congressional Democrats have insisted they will not negotiate over a debt ceiling increase.

Our outlook for the debt ceiling is that a resolution will ultimately be reached, but will likely follow the pattern of nearly every other recent fiscal negotiation: demagoguery and brinkmanship up front, followed by a deal cobbled together at the eleventh hour. What that deal might look like is uncertain, although there is speculation that a large, comprehensive deal that includes cuts to entitlement spending and revenue raisers could be in the works. While the public has been enchanted by this talk of a so-called grand bargain before, we think the same obstacles from the past two years remain today: Republicans want cuts to entitlement spending without any tax increases, and Democrats will only agree to entitlement cuts if they involve substantial tax increases.
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