This deadlock is creating huge waves in the financial markets, with effects on liquidity comparable to multiple rounds of interest rate hikes.

Written by: Ye Zhen

Source: Wall Street Journal

The U.S. government shutdown is pushing the financial markets to the brink of danger, but there are hidden opportunities in the crisis. Signals of progress in negotiations between the two parties in Congress have emerged, with some Republican lawmakers optimistically predicting that an agreement may be reached this week.

On Tuesday, the U.S. market experienced a "Black Tuesday." Warnings from CEOs of major Wall Street banks about the overvaluation of U.S. stocks ignited investor anxiety, compounded by concerns over the worsening liquidity crisis due to the government shutdown, leading to a massive sell-off of risk assets. The Nasdaq and S&P 500 indices recorded their largest single-day declines in nearly a month, with technology and semiconductor sectors being the hardest hit.

Panic quickly spread to other markets. Bitcoin fell below the $100,000 mark for the first time since June, triggering a massive liquidation of over $1.3 billion in the cryptocurrency market. Safe-haven sentiment pushed the U.S. dollar index to rise for the fifth consecutive trading day, reaching a three-month high, while the British pound, offshore yuan, and commodities generally faced pressure.

At the core of this market turmoil is the political deadlock in Washington. On Tuesday, the current U.S. government shutdown entered its 35th day, matching the longest shutdown record set in 2018-2019.

However, according to media reports, some Republican lawmakers predict that the deadlock may end this week. Republican Senator Markwayne Mullin from Oklahoma expressed that he is "very confident" about reaching an agreement this week, specifically noting, "I think we could finish by tomorrow (Wednesday) night… but it's more likely to be Thursday."

"Shutdown equals rate hike": Liquidity crisis emerges

Behind the market's violent fluctuations is an increasingly severe liquidity crisis, with the government shutdown seen as a major driving force.

According to a previous article from the Wall Street Journal, analysis shows that the shutdown has forced the U.S. Treasury to increase its General Account (TGA) balance at the Federal Reserve from about $300 billion to over $1 trillion in the past three months, setting a nearly five-year high. This process is equivalent to withdrawing over $700 billion in cash from the market.

This large-scale liquidity withdrawal has a tightening effect comparable to several interest rate hikes. Key financing rate indicators are all under pressure. According to Bloomberg, the Secured Overnight Financing Rate (SOFR) surged by 22 basis points on October 31, far exceeding the Federal Reserve's target interest rate range, indicating that the actual financing costs in the market have not decreased with the Fed's rate cuts. Meanwhile, the usage of the Fed's Standing Repo Facility (SRF) is also approaching historical highs.

Data shows that the Federal Reserve's bank reserves have fallen to their lowest level since early 2021. Bank of America liquidity experts Mark Cabana and Katie Craig warned that the deterioration of funding conditions could exhibit dangerous self-reinforcing characteristics, which, if not addressed, could trigger a repo crisis similar to that of September 2019.

Turning point on Thursday? Bipartisan negotiations show glimmers of hope

Despite the increasing pain in the markets, the political deadlock seems to be approaching a "breaking point."

According to media reports, as the government shutdown enters a record 35th day, some senators predict that the deadlock may end this week. Republican Senator Markwayne Mullin from Oklahoma stated that he is "very confident" about reaching an agreement this week, specifically noting, "I think we could finish by tomorrow (Wednesday) night… but it's more likely to be Thursday."

Mullin and other Republican lawmakers believe that Tuesday's local elections are a key factor. They claim that Democratic leader Chuck Schumer previously instructed his members to postpone voting to avoid suppressing turnout among liberal voters. Missouri Republican Senator Eric Schmitt predicted that after the elections, Democrats would no longer have a reason to continue obstructing.

The impact of the shutdown on people's livelihoods is becoming increasingly evident, putting immense pressure on both parties. According to the Financial Times, funding for the Supplemental Nutrition Assistance Program (SNAP, or food stamps), relied upon by over 40 million Americans, expired last weekend, and some areas have also closed preschool programs for low-income children. Analysts from Goldman Sachs and Citigroup also predict that the government is likely to reopen within the next two weeks.

Divisions within the Democratic Party emerge

However, the path to reaching an agreement is not smooth, as clear divisions have emerged within the Democratic Party.

According to media reports, some moderate Democrats, unable to bear the pain of the shutdown, are considering accepting a compromise: first passing a temporary funding bill to reopen the government in exchange for a commitment from Republicans to vote on extending subsidies for the Affordable Care Act (ACA) in the future.

But this "reopen first, vote later" plan has angered progressives within the party.

Vermont Senator Bernie Sanders stated that if Democrats "yield" on this point, it would be a "betrayal of millions of working families." Connecticut Senator Chris Murphy also expressed that believing a party that opposes extending subsidies now would change its stance in a month is nothing short of "self-deception."

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