Saturday, June 3, 2023

Debt limit in America and its policy on the verge of abyss

Madrid. We’ve seen this playbook play out many times before, with the political stance taken to the point of ‘fragility’ before a last-minute deal on the US debt ceiling. The political backdrop of the current debt ceiling talks is volatile to say the least, and accidental bankruptcy remains a significant risk – although not our baseline scenario – given the uncertainty around the ‘X date’. borrowing capacity.

History can be a useful guide, and comparisons have been made with similar events in 2011, when the debt ceiling was raised with only two days remaining. Market reaction was tied to a severe loss of confidence, with US Treasuries rallying despite the loss of their ‘AAA’ rating, safe haven currencies underperforming and credit spreading.

However, caution should be exercised when making direct comparisons with this period: the market environment was very different then. At the same time, the eurozone was facing its own challenges and peripheral country bonds spread rapidly, leading to weakness in other cyclical assets. Similarly, US activity data was also deteriorating significantly, making it more difficult to tease out some of the factors driving the market at the time.

This time we are nearing the end of one of the most aggressive rate hike cycles in the last 40 years and they are already too high. In addition, we also have the headwinds that difficult debt conditions stand to develop. So far, the market has been somewhat bullish on the prevailing risks.

Treasury bills maturing around the expected ‘X date’ have become significantly cheaper and US sovereign credit default swaps (CDS) are trading at a wider spread than in 2011. Very different interest rate environment. However, volatility in riskier assets and currencies remains subdued for the time being, consistent with the view that some markets are hedging these risks.

History shows that volatility tends to increase closer to ‘date X’. Although the market is aware of this trend, volatility may increase already this time. As per our analysis, markets would be anticipating a more severe cyclical slowdown, which would lead to credit expansion. In other words, high-yield bonds will yield less than investment-grade bonds, government bonds will rally, and the US dollar will weaken, especially against defensive currencies such as the Japanese yen.

Fed ammunition

However, it is worth noting that this time the US Federal Reserve (FED) has much more ammunition to cut interest rates, which may have different implications for the shape of the curve. In 2011, the risk curve revolved around flattening. Some expansion is likely to be given to allow for more meaningful dialogue. While this may provide a period of respite for the markets, it will not be the end of the story and uncertainty is likely to remain.

The blow to confidence contributed to slowing global growth and a period of deflation, which is likely to exert downward pressure on government bond yields. However, a more volatile market environment lends itself to more agile positions and careful position sizing.

Nation World News Desk
Nation World News Desk
Nation World News is the fastest emerging news website covering all the latest news, world’s top stories, science news entertainment sports cricket’s latest discoveries, new technology gadgets, politics news, and more.
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