Why Is a Shutdown Possible by October 1st?

Our Global Head of Thematic and Fixed Income Research Michael Zezas and our U.S. Public Policy Strategist Ariana Salvatore unpack the market and economic implications of a looming government shutdown.

Read more insights from Morgan Stanley.

----- Transcript ----- 

Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Morgan Stanley's Global Head of Fixed Income Research and Public Policy Strategy. 

Ariana Salvatore: And I'm Ariana Salvatore, U.S. Public Policy Strategist. 

Michael Zezas: Today, our focus is once again on Washington – as the U.S. government fiscal year draws to a close and a potential government shutdown hangs in the balance.

It's Friday, September 26th at noon in New York. 

Ariana we're just four days away from the end of the month. By October 1st, Congress needs to have a funding agreement in place, or we risk a potential shutdown. To that point, Democrats and Republicans seem far apart on the deal to avoid a shutdown. What's the state of play? 

Ariana Salvatore: Right now, Republicans are pushing for what's called a clean continuing resolution. That's a bill that would keep funding levels flat while putting more time on the clock for negotiators to hammer out full fiscal year appropriations. And the CR they're proposing lasts until November 21st. 

Democrats, conversely, are seeking to tie government funding to legislative compromise in other areas, including the enhanced Obamacare or ACA subsidies, and potential spending cuts to Medicaid from the One Big Beautiful Bill Act, which Republicans signed earlier this year. Remember, even though Republicans hold a majority in both chambers, this has to be a bipartisan agreement because of exactly how thin those margins of control are. 

But Mike, it seems as we get closer, investors are asking more infrequently whether or not a shutdown is happening – and are more interested in how long it could potentially last. What are we thinking there? 

Michael Zezas: So, it's hard to know. Shutdowns typically last a few days, but sometimes there are short as a few hours, sometimes as long as a few weeks. Historically, shutdowns tend to end when the economic risk, and therefore the attached political risk gets real. So, consider the 35-day shutdown under President Trump in this first term. 

The compromise that ended it came quickly after there was an air traffic stoppage at New York's LaGuardia Airport – when 10 air traffic controllers who weren't being paid failed to show up for work. 

So, we think the more relevant question for investors is what it all means for economic activity. Our economists have historically argued that a government shutdown takes something like 0.1 percent off of GDP every single week it's happening. However, once employees go back to work, a lot of times that effect fades pretty quickly. 

Now it's important to understand that this time around there could be a wrinkle. The Trump administration is talking about laying employees off on a durable basis during the shutdown. And that's something that maybe would have more of a lasting economic impact. It's hard to know how credible that potential is. There would almost certainly be court challenges, but it's something we have to keep our eye on that could create a more meaningful economic consequence. 

Ariana Salvatore: That's right. And there are also some really important indirect macroeconomic effects here. Like delayed data releases. Much of the federal workforce, to your point, will not be working through a shutdown – which could impede the collection and the release of some key data points that matter for markets like labor and inflation data, which come from BLS, the Bureau of Labor Statistics. 

So, assuming we're in this scenario with a longer-term shutdown. Obviously, we're going to see an increase in uncertainty, especially as investors are looking toward each data print for guidance on what the Fed's next move might be. What do we expect the market reaction to all of this to be? 

Michael Zezas: Well, the obvious risk here is that markets might have to price in some weaker growth potential. So, you could see treasury yields fall. You could see equity markets wobble; be a bit more volatile. It could be that those effects are temporary, though. And that volatility could easily be amplified by having to price risk in the market without the data you were talking about, Ariana. So, investors could overreact to anecdotal signals about the economy or underweight some real risks that they're not seeing. 

So, that's why even a short shutdown can have outsized market effects. Well, Ariana, thanks for taking the time to talk.

Ariana Salvatore: Great speaking with you, Mike. 

Michael Zezas: And to our audience, thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you get this podcast and tell your friends about it. We want everyone to listen.