What Happens When Washington and Wall Street Collide?

Like it or not, there's a direct link between Washington, D.C., and Wall Street. I'm not talking about the Amtrak that connects the two; I'm talking about when Washington begins to impact Wall Street and when Wall Street makes demands of Washington.

The back-and-forth between the two has been going on for years, but there's a new relationship now that gridlock is commonplace in Washington, and Wall Street now impacts nearly every American's bank account in one way or another.

This week was a prime example of how the two interact. On Wednesday, there appeared to be little hope in negotiations to reopen the government and the Dow Jones Industrial Average (DJINDICES: ^DJI  ) fell below 14,800, which is the lowest level since early summer.

Then came reports that House GOP members were backing down from some of their demands and President Obama was willing to negotiate on the budget and debt ceiling. From the low on Wednesday (14,719.43) to the close on Friday, the Dow Jones Industrial Average jumped 3.52%, just on hopes for a deal in Washington. If talks break down, we can assume the opposite will happen as we careen toward default on Thursday.

This isn't the first time Wall Street has booed or cheered what Washington has done. Recent history shows that the stock market has been a great driver of policy in Washington.

The biggest drop in Dow Jones history
As the financial crisis was unfolding, it became apparent to the market that government intervention would be necessary to avoid economic catastrophe. In the wee hours of the morning on Sept. 29, 2008, leaders of the House and Senate and Treasury Secretary Paulson announced that a tentative deal had been reached to approve a $700 billion asset-buying program later known at TARP.  

When markets opened on Monday morning, the Dow Jones Industrial Average opened down a minuscule 4 points, as if it were business as usual. But during the trading day, the House of Representatives voted down TARP by a 205-228 margin and the Dow proceeded to fall 778 points to close Monday, down 6.98%. A message was sent to Washington that something needed to be done.  

^DJI Chart

^DJI data by YCharts.

The reaction was so swift that by Wednesday, Oct. 1, 2008 TARP had passed the Senate and was through the House by the end of the week. After booing the bill's failure on Monday, markets recovered on Tuesday and Wednesday because it appeared a deal was near. Wall Street was a major reason for the change of tune in Washington and, by Friday night, a similar bill that failed by 205-228 in the House passed 263-171.

The not-so-distant past
Unfortunately, this back-and-forth has become commonplace. The last time the government came close to hitting the debt ceiling, the markets tanked leading up to and after the debate was over. Below is a chart of the Dow Jones Industrial Average and you can see that from July 21 to August 8, the index dropped 14.2%.

^DJI Chart

^DJI data by YCharts.

An agreement to raise the debt ceiling was reached on July 31, before the August 2 deadline, but it came with major spending cuts that affected economic growth. To make matters worse, on August 6, the S&P downgraded U.S. debt from AAA to AA+.

The market is already reacting
This week, the stock market is up but bond markets are still worried. Treasury bills due October 17 and October 24 hit 0.51% and 0.50% yields, respectively, this week. This might not seem like a high rate, but they've been trading for a 0.2% yield recently and a jump like that is unusual, to say the least.

Treasuries are considered the safest securities in the world and, if there's a default, the fallout will be widespread. Fellow Fool Morgan Housel recently called Treasuries the "cornerstone of the global financial system" and if repayments are suddenly put into question, the financial house of cards begins to fall apart.

A rise in short-term yields was the first reaction from the market and it coincided with breakthroughs in this year's negotiations. Don't underestimate the effect that a falling stock market and rising interest rates have on Washington, because in the past and this time around, they impact each another.

Foolish takeaway
What's important to take away from this is that markets matter to the government and government matters to markets. Ironically, it appears that the best way to tell Washington how important a topic this has been is through the markets, because that's when policy starts to impact people's wallets.

TARP didn't pass until the market showed how important it was: The debt ceiling debate in 2011 led to a mini-crash and the loss of our AAA credit rating. There are only five days left before default becomes a real possibility, and I wouldn't be surprised to see a sharp market reaction if negotiations go south over the weekend. Maybe that will be the pressure Congress and the president need to get a deal done, something we've seen more than once before.

Don't let Washington scare you out of investing
After debates like the past week, it's easy to understand why millions of Americans have waited on the sidelines since the market meltdown in 2008 and 2009, too scared to invest and put their money at further risk. The problem is that those who've stayed out of the market have missed out on huge gains and put their financial futures in jeopardy. In our brand-new special report, "Your Essential Guide to Start Investing Today," The Motley Fool's personal finance experts show you why investing is so important and what you need to do to get started. Click here to get your copy today -- it's absolutely free.


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