• Investors have turned their attention to the impending debt ceiling issue
• Government payment disruptions and technical default probabilities are beginning to be priced into Treasury securities
• In the best analog to the current situation, the 2011 debt ceiling crises can provide some clues into market reactions and investor behavior
• These events tend to be short-term, heated political affairs that often extend right up to the deadline, resulting in much higher than normal levels of market volatility
• As a resolution is ultimately the only path forward, any ensuing turmoil may provide attractive opportunities for both equity and fixed income active investors
Completely Predictable, but Now with a Sense of Urgency…
In what is now becoming a politically-motivated biannual event, the US once again reached its debt ceiling limit established by Congress in 2021 ($31.4T) this past January. Even with nominal public debt growing at only about a 2% compound annual growth rate (CAGR) over the past five years, it was a mathematical certainty that the debt limit would be breached sometime this year. Unless the debt ceiling is raised, extended or abolished prior to the “X-date”, or the date in which the Treasury actually exhausts available cash, investors should expect very high levels of volatility across most asset classes.
(Update: On May 1, Treasury secretary Janet Yellen injected a sense of urgency to Congress when she said the actual “X-date” could be as soon as June 1. Also sensing the urgent nature, President Biden and Speaker of the House McCarthy agreed to meet on May 9. While the two sides remain miles apart in terms of their agenda, this is a key meeting to determine if a realistic compromise can happen quickly.)Short Treasury Bills React Immediately…and offer Good Insight into Timing and Duration of any Non-Payment or Maturity Extensions
Short-term US Treasury securities (T-bills) with maturities beginning on 06/01/2023 reacted violently to the news, just as they did in 2011. In 2011, short T-bills traded hands at 8-10% up until the resolution two days prior to the X-Date in August, 2011. In that situation, Congress compromised to extend the debt ceiling with spending and tax cuts attached.
Many investors, such as money market funds, hold short-term treasury bills. Instead of dealing with any repercussions and uncertainty in pricing from a default or maturity extension, their first inclination is to sell. That is what we witnessed on 05/02/2023 as at one point the 06/01/2023 maturity sold off 80 basis points (bps). The group of securities (in the window of default) are now the highest yielding along the treasury curve. The rest of the T-bill market, those with maturities later than 07/05/2023, rallied which signaled that the market expects a resolution to occur within a month.
Risk Off/On Asset Class Performance
The prospect of a government default has different implications for traditional risk on/off sectors. It may seem ironic, but long term Treasuries are typically the beneficiaries in what is a risk-off environment during any debt-ceiling impasse. For starters, longer term Treasury securities only require interest payments and the debt ceiling events, if they result in lower government spending, lower gross domestic product (GDP) or equity market turmoil tend to benefit Treasury Bonds. For example, as of 05/02/2023, all Treasury Bond maturities saw yields fall 10 to 20 bps. By contrast of magnitude, the ten-year fell 80 bps during the one-month period prior to the 2011 X-Date deadline. After the debt deal was reached in 2011, S&P downgraded the US from “AAA” to “AA+” and there was muted market reaction to that downgrade.
However, risk assets did not fare well in the 2011 episode, with the US dollar, equities and credit spreads all taking a hit. Particularly hard hit were small and mid-cap stocks, and the sector performance across all market weightings followed the risk-off theme with consumer staples and utilities performing best. For comparison, in the one-month prior to the 2011 X-Date small cap equities were -3.61% versus -2.03% for the SPX.
What’s Different This Time?
There are many political similarities between this impasse and the one that almost led to a default in 2011. However, there are differences as well. First, the economic and monetary policy backdrop is markedly different from 2011. In 2011 the Federal Reserve (Fed) held short term rates at 0% and was engaged in Quantitative Easing (QE). Today the exact opposite policy response is occurring—the Fed is raising rates to 5% and is engaged in Quantitative Tightening (QT). This fact alone could significantly elevate or mute fixed income market reactions as the situation unfolds, and it could even result in the Fed changing its monetary policy stance.
Secondly, equity market valuations are much higher today (such as by the S&P earnings yield ratio) than they were in 2011. So any economic fallout deemed to impact earnings or financial stability may be met with more elevated downside risk.
Up until now we have focused on Treasury bill market pricing as the initial volleys begin to be served up in the debt ceiling negotiations, primarily because they are the first market where assumptions to the debt ceiling issues can be directly observed.
However, we (and the market) currently believe it is a solid bet that a default will be averted. It is difficult to pinpoint how that is going to be accomplished but there are outs for both sides for a temporary solution, perhaps to October when the annual budget appropriation discussions begin. Stay tuned for that as well.
At stake on both sides of the political fence is fiscal responsibility and a social contract to pay our bills and provide services to our citizens. Both are required and are non-negotiable. An actual default, not contemplated here at this time, would have consequences that span the globe. However, until a deal is ultimately reached, there could be more blood in the market. These are the times active management can find attractive entry points.
Important Disclosures & Definitions
Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.
One may not invest directly in an index.