The United States is teetering on the edge of its 22nd federal government shutdown since 1976. While markets are dismissive—assuming, as in the past, that “nothing is going to happen”—this is more than just domestic political theater. If not resolved quickly, this shutdown could become a severe stress test for a global financial system already riddled with liquidity issues, a theme I highlighted three months ago in “LIQUIDITY CRACKS WIDEN IN THE GLOBAL FINANCIAL HOUSE OF CARDS“
Objectively, the risk of a US debt default is low. The US Treasury General Account (TGA) is flush with $786.34 billion, bolstered by recent quarterly tax inflows. However, prolonged political uncertainty could spark serious trouble in the “plumbing” of the global financial system.
Markets have weathered 21 prior shutdowns (totaling ~170 days since 1976), typically treating them as transient noise. Statistically, shutdowns have even been bullish for stocks, which performed positively in 86% of these episodes. The median S&P 500 performance post-shutdown stands at +12.7% in the following 12 months. Other assets like gold, silver, and US Treasuries have historically been unfazed, showing only a slight risk-off bias.
The US Treasury also has a well-established toolkit to mitigate fallout. It prioritizes critical payments to avoid a default, and if it nears the debt limit, it can employ “extraordinary measures.” These include suspending investments in funds like the Civil Service Retirement Fund (freeing up ~$100-200 billion) or halting reinvestments in the Thrift Savings Plan G Fund (~$50-100 billion). Interest payments on US debt remain the absolute top priority; failure here would trigger a technical default and global financial Armageddon.
The risk lies not in the shutdown itself, but in its duration intersecting with an already fragile liquidity backdrop.
- A seven-day shutdown—aligning with the historical average—would likely inflict negligible systemic harm. The impact on GDP would be a rounding error, furloughs would briefly affect ~800,000 workers, and markets would shrug.
- An extended shutdown beyond two weeks would start increasing market risks, costing 0.3-0.5% of GDP, furloughing 1.5 million workers, and triggering liquidity tensions. Yet, once resolved, investors would quickly forget.
- A 35+ day saga—matching the 2018-19 record—could spell serious trouble. It would idle 2 million workers and delay hundreds of billions in contracts at a time of high inflation, while half the population lives paycheck to paycheck. If consumer insolvencies skyrocket and people start draining deposits, problems could escalate rapidly for banks already saddled with a mountain of increasingly radioactive illiquid assets, especially commercial real estate loans, which they cannot sell for liquidity without booking steep losses.
Imagine a shutdown dragging past 35 days. A political standoff could accidentally trigger a liquidity crisis event that can quickly morph into a bank run similar to the one that took down SVB, First Republic, and Credit Suisse in 2023.
The system’s reserves are the lifeblood of money markets. Normally, the TGA acts as a cash buffer, but during a shutdown, the government draws down the TGA only to meet critical payments, which increases TGA balances and effectively siphons reserves from the banking system. As you can observe in the chart, banks’ reserve balances have been decreasing rapidly since July, and are currently not far from the lows of 2023, when the US regional banks’ crisis sparked.
In a prolonged shutdown, this reserves drawdown becomes sustained. The system loses its margin of safety. Even if aggregate reserves seem sufficient, they become unevenly distributed. Some banks, especially those active in trading, find their usable cash positions strained. Furthermore, as I addressed in “WHAT HAPPENS TO STOCKS WHEN THERE WON’T BE ANY CASH ON THE SIDELINES LEFT?“, there is very little “cash on the sidelines” that can help to support the fragile status quo of the financial system upon which the biggest stock bubble in history stands.
This is where the repo market—the core plumbing connecting cash and collateral—begins to fail. Entities needing short-term funding compete for a shrinking pool of cash. If cash tightens, the repo rate spikes. Lenders hoard cash, raising funding costs further. We saw this in September 2019 when repo rates exploded from 2.5% to over 10%, forcing the Fed to intervene and quickly inject $250 billion into the money market system (“What Happened in Money Markets in September 2019?“).
In a 35-day or longer shutdown, these stresses would unfold on a broader scale. As repo markets tighten, banks will have to liquidate assets or hoard cash, exacerbating price dislocations. Simultaneously, they face stress from the deposit side: job losses and uncertainty cause households and businesses to draw down deposits.
At some point, this stress shifts from a financial system plumbing problem to a classic bank run. Confidence erodes, depositors rush to move money, and banks fire-sell assets, pushing down valuations and further tightening liquidity. The system, interconnected through exposures, begins to seize.
At this moment, the Federal Reserve would be forced to step in—not as a minor adjuster, but as the plumbing’s ultimate backstop. It would likely reintroduce large-scale repo operations, expand lending facilities, potentially restart large-scale Treasury purchases to rebuild reserves, and even consider unconventional interventions like the BTFP facility used in 2023 to effectively inject temporary capital into struggling banks without congress approval (yes, the FED instead of lending liquidity based on the market value of US treasuries collateral and other eligible securities, it instead lent liquidity at par value effectively injecting profits, hence capital, into banks).
In conclusion, I recognize that rising markets are a primary concern for politicians. However, during a shutdown, the President cannot simply eliminate what bothers stocks as it consistently did so far to the point there is a new term for it: TACO. Currently, one political side benefits from the status quo, while the other seeks a political victory and to regain consensus ahead of next year’s mid-term elections in the US. This second party, though, must be careful not to be blamed for triggering a non-temporary economic crisis—or worse, a global financial crisis. In the coming days, vigilance is key. The question is not if a shutdown will cause a US default—it almost certainly won’t. The real danger is that a lengthy political standoff keeping the Federal government operations shut triggers a banking crisis that combines the 2019 repo shock with 2023’s poor asset liquidity crisis.
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