LONDON, Oct 11 (Reuters) - Economic uncertainty from the U.S. budget impasse and the government shutdown is introducing a new policy risk to investors: instead of tapering, could the Federal Reserve actually boost monetary stimulus?
Although not yet a mainstream market assumption, the chance that U.S. monetary policy could move in either direction may encourage investors to shift their portfolios in favour of safer government bonds - and away from U.S. stocks which had led the rally earlier this year.
In the past three episodes of quantitative easing that began in November 2008, equity and other risky assets rallied.
But a possible fourth round of stimulus could actually have a negative impact on risky assets, in part because it raises the risk of a bigger, sharper withdrawal in the future.
In its 10th day, the U.S. government shutdown is delaying key economic data releases and threatening to hurt business confidence, consumer spending and the growth outlook.
"Whatever the outcome of budget negotiations, it's reasonable to expect we'll end up with a tighter fiscal position. The Fed may feel a looser monetary policy is the appropriate balance to that environment to ensure economic recovery," said Andrew Cole, investment director at Baring Asset Management.
"We don't think there's a bad value in Treasuries. It's difficult to imagine an environment in the next 12-18 months where you see a significant rise in bond yields because that would threaten an economic recovery and equity valuation."
Before the budget gridlock started, 9 economists out of 17 surveyed by Reuters after the Fed's surprise move to keep its bond purchases in September said the central bank would move in December.
Cole said if the Fed saw a need for more monetary stimulus, it may resort to other parts of its policy toolkit such as encouraging banks to lend more to businesses.
"It is the nature of policy response that would be the key determinant here. If they were to do more quantitative easing I think the market would be sceptical of the impact that would have in generating economic activity," he said.
After a four-month sell-off which took the benchmark yield to a two-year high, U.S. Treasuries have stabilised and the yield has stayed below 2.7 percent. Treasuries are actually one of the best performing asset this month.
U.S. stocks led the global equity rally in the first half of the year, and they still enjoy year-to-date gains of nearly 20 percent.
But Europe, and to a lesser extent Japan, have put in better performances over the past three months as growth momentum picks up. Rotation away from the United States may speed up if the uncertainty around Fed policy grows.
"We're genuinely a bit more concerned for the outlook for corporate profits and the market has paused after what's been a very strong run for U.S. equities. You may start to think about rotating from U.S. stocks into Europe and Japan," Cole said.
According to Bank of America Merrill Lynch, European equities have now seen 15 straight weeks of inflows.
Thomson Reuters Lipper data shows investors pulled $8.9 billion out of funds that mainly hold U.S. stocks while pouring $590 million of new cash to European stock funds in the week to Oct 9.
The budget deadlock has thrown in fresh uncertainty over when the Fed will scale back its $85 billion month bond purchases programme - or if it could move at all.
That may be enough to make investors more cautious about their positioning. Nomura has gone neutral on cash from underweight, moved to a modest overweight in government bond duration and shifted to a more neutral stance on equities.
Lombard Odier prefers to keep a bullish stance on bonds.
"In case of a debt ceiling hit, the case for more QE is clear. However, even under the more likely scenario of a deal, latest hit to consumer confidence and data uncertainty has increased the likelihood of an increase on the margin," said Salman Ahmed, strategist at Lombard Odier Asset Management.
"We retain our bullish stance on duration for now." (Editing by Toby Chopra)