Foroohar: The Gridlock Economy Blues

Get ready for markets where blue chip stocks trump government bonds, and politics trump the economy

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Brendan Smialowski / AFP / Getty Images

Oct. 1, 2013. The Lincoln Memorial on the National Mall in Washington. The United States lurched into a dreaded government shutdown for the first time since 1996.

The crisis in Washington has kept us all on tenterhooks--watching for signs of a deal on federal spending and the debt ceiling amid ever more dire prognostications. We've now heard plenty about the consequences, perceived or real, of the U.S.'s defaulting on its debt: a plummeting S&P 500 index, a Chinese sell-off of U.S. T-bills and even a new global recession. All those things are possible. But ultimately, resolving the debt ceiling is unavoidable; the only issue is how much pain and loss we incur along the way. A more interesting--and answerable--question is what Washington's on-and-off gridlock tells us about the economic milieu we're already in. Here are three key market trends under way regardless of any D.C. deals.

Interest rates will rise. After all, they can't go down any further.

In fact, rates on short-term T-bills already spiked amid the uncertainty over the U.S.'s ability to pay its obligations. The question is when and how we'll see a longer-term rate increase. The best-case scenario has the Federal Reserve able to slowly but surely end its $85-billion-a-month asset-buying program, "taper" back on the money dump and gradually raise rates over the next year or two. Getting the timing of that right will be the key challenge for incoming Fed Chair Janet Yellen, whose confirmation will likely go through. Already, there are worries that low rates are causing market bubbles, which are always a risk when you have an easy-money environment for years on end. (Think Iceland, Argentina and subprime debt.)

But gridlock has made smart and timely tapering more complicated. Since Congress has been unwilling to boost the economy, the Fed has been forced into the role of stimulator of last resort. Part of the Fed's mandate involves keeping unemployment low, which requires higher growth than what we currently have. It's very likely that the shutdown will shave half a percentage point of growth from our already weak economy, meaning we may not expand by even 2% this year.

Political uncertainty creates a scenario in which interest rates can rise suddenly and unpredictably, as we've already seen in the bond markets in recent weeks. Market anxieties are evident in the recent boom in U.S. sovereign credit-default swaps. In snapping up swaps, investors are effectively purchasing insurance against the U.S.'s defaulting on its debts. Even if short-term rates and risk perceptions go back down, with so much Fed-generated money floating around in the market, "interest rates must eventually rise," said hedge funder Ray Dalio, founder of Bridgewater Associates, at a recent presentation at the Japan Society in New York City. "That means that the cost of debt will rise too."

As anyone who's been trying to get a mortgage lately knows, that ship has already begun to sail. As rates go up, the price of everything from homes to cars to consumer goods rises too. Returns on investments of all sorts will fall, since higher interest payments erode profit margins. "The future return on nearly all asset classes is going down," says Dalio. That's what some investors call the New Normal.

Stocks could displace bonds as the safety asset of choice.

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