Wall Street braces for volatility as shutdown seems likely

NEW YORK Sun Sep 29, 2013 3:43pm EDT

Traders work on the floor of the New York Stock Exchange shortly after the opening of markets in New York, September 4, 2013. REUTERS/Lucas Jackson

Traders work on the floor of the New York Stock Exchange shortly after the opening of markets in New York, September 4, 2013.

Credit: Reuters/Lucas Jackson

NEW YORK (Reuters) - As a last-minute deal to resolve spending negotiations in Washington appeared less likely, U.S. stock investors braced for what had previously seemed remote: a shutdown of the U.S. government that could spark a major equity decline.

The House of Representatives early on Sunday voted for an emergency spending bill that includes a delay of President Barack Obama's signature healthcare reform law despite veto threats from the White House.

While a deal could be reached before the government's fiscal year ends at midnight on Monday, the unanimous passage of a bill to continue paying U.S. soldiers in the event the government runs out of money was viewed as a sign that there would be no agreement between Republicans, who hold a majority in the House, and the Democrats, who control the White House and Senate.

Among the consequences of no deal being reached are many government employees will be furloughed, and the Labor Department will not issue its monthly employment report scheduled for next Friday.

A shutdown is expected to have a major impact on markets, injecting massive amounts of uncertainty into all asset classes. If a deal is reached quickly, that might allow markets to recover, but a prolonged shutdown could have significant implications for economic growth and consumer confidence.

"A shutdown is just one domino; if it falls, it will cause a series of unknowns, and those unknowns are impossible to quantify," said Adam Sarhan, chief executive of Sarhan Capital in New York. "The immediate shock could be 200 Dow .DJI points, could be 1,000 Dow points. Those moves may be exaggerated at first, but if things aren't resolved quickly that could just be the start."

The S&P 500 .SPX is currently 0.7 percent above its 50-day moving average of 1,680.18, a level that has been serving as support, but the index is likely to break below it in the case of major uncertainty. The next key level is the index's 100-day average of 1,659.29, 1.9 percent below current levels.

Historically, Wall Street has managed to avoid steep downside during similar incidents. During the federal government shutdown from December 15, 1995, to January 6, 1996, the S&P 500 added 0.1 percent. During the November 13 to November 19, 1995, shutdown, the benchmark index rose 1.3 percent, according to data by Jason Goepfert, president of SentimenTrader.com.

That precedent may not hold this time given that growth continues to lag. The U.S. Federal Reserve recently held off on slowing its stimulus program, saying economic growth was not meeting its targets.

Since the market is near all-time highs and has seen little in the way of a sustained pullback this year, Sarhan said the downside potential was vast, with the S&P 500 "slicing through" support levels before finding support around 1,550, a level that is 8.4 percent below its Friday closing price.

While the threat of a shutdown has weighed on markets recently, with the S&P snapping a three-week streak of gains to fall 1.1 percent last week, many investors considered the prospect unlikely. The S&P is up 3 percent this month, and is a mere 2 percent away from its all-time high.

The CBOE Volatility index .VIX spiked about 18 percent last week, but remains sharply down for the year, suggesting little concern is priced into markets. The VIX closed Friday at 15.46, a level that is very low by historical standards.

Analysts had viewed a shutdown as unlikely, with many citing other government stalemates that were resolved in the past few years. However, political infighting in 2011 prompted the loss of the United States' triple-A credit rating and was the primary driver of the stock market's last full-on correction.

Essentially all market sectors could see a reaction to a shutdown, with industries tied to the pace of economic growth- like energy and financials- seeing outsized impacts.

The defensive sector "will feel an immediate impact since its biggest customer is the U.S. government," said Sarhan. "We're talking billions of dollars in income. If that goes away, what could replace that?"

Even utilities, which are considered a defensive group, may see steep moves if a shutdown impacts interest rates.

Among other asset classes, the uncertainty could been a boon for U.S. Treasuries as investors seek shelter. Benchmark 10-year Treasury notes rose 10/32 on Friday, with yields easing to 2.62 percent.

Analysts at Brown Brothers Harriman said the U.S. dollar .DXY was likely to weaken, and that it looked vulnerable against the yen.

Even if a last-minute deal is reached, investors face a second Washington cliffhanger as Congress must agree to increase the $16.7 trillion limit on federal borrowing by October 17. If Capitol Hill fails to act in time, the unthinkable could happen and the United States could default on its debts.

"We're in a game of chicken. Once it became clear that people were willing to risk Federal employee jobs, that's when it became a real concern," said Len Blum, managing partner of Westwood Capital LLC in New York.

"We've become somewhat desensitized to this kind of apocalyptical thing coming out of D.C., but as time goes on with no resolution, it will get increasingly bad."

(Editing by Marguerita Choy and Leslie Gevirtz)