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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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Investment implications

These policy debates have important ramifications for investors and could drive market volatility higher in coming months.
The first two debates, regarding government funding and the debt ceiling, pose challenges to both risk asset valuations and volatility markets. Political rhetoric that threatens to shut down the government or default on government debt is inherently destabilizing. However, in what perhaps is a sad commentary on the state of affairs, the markets now expect very little out of Washington and have become accustomed to politicians taking us to the brink of fiscal catastrophe.

During the fiscal cliff debates at the turn of the year, markets did not react negatively to Congress's lack of a resolution until the week between Christmas and New Year's. Thus, the market base case in this next round of fiscal negotiations is for another last-minute, kick-the-can deal, so the risk to markets is more of a tail risk that Congress cannot compromise this time, which would likely lead to sharply lower risk asset valuations and sharply higher implied volatilities. Investors concerned with such a scenario may look to buy downside puts on equity and credit indexes. These hedges currently trade at attractive levels compared with much of the post-crisis era given recent market stability.

While the potential impact of the government spending and debt ceiling debates on markets is more of a one-sided tail risk, the back and forth of the Fed chair debate will likely continue to sway markets over the next few months.

If Yellen becomes the Fed leader, a dovish mistake of staying accommodative for too long is a greater risk than one of withdrawing accommodation prematurely. A Yellen appointment would likely lead to Treasury yields remaining extraordinarily low (or lower), the yield curve remaining steep, TIPS (Treasury Inflation-Protected Securities) outperforming due to risks of future inflation and mortgage credit tightening due to a willingness to engage quantitative easing.

The Fed under Summers would perhaps be more susceptible to a hawkish policy mistake than it would be under Yellen. He is less likely to support the Fed's balance-sheet-expansionary policies for as long as Yellen would, which would mean relatively higher nominal Treasury yields and mortgage credit spreads, all else equal.

The potential impact on equity markets is more ambiguous. Some believe Yellen's policies are more supportive of equity valuations, which have relied upon (and possibly are addicted to) extraordinary Fed liquidity provision. By contrast, others believe that Summers' more optimistic outlook for the economy and likely willingness to "hand off" from public sector support to the private sector is exactly what equity markets are ready for and need for long-run investor confidence.

Regardless of who the ultimate nominee is, we expect the debate will increasingly lead to greater uncertainty and greater market volatility. Added to the potential volatility from the government spending and debt ceiling debates, investors should brace for a bumpy road ahead this fall.

This article originally appeared on PIMCO.
No positions in stocks mentioned.
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