The debt ceiling debate is certainly reaching a fever pitch this spring, making many market participants wonder will policy makers hit a home run or strike out? As going into extra innings with this will be far worse than a rain delay.
In this special edition of Adding Alpha, we take a look at various debt ceiling scenarios and the market implications for each. Since 1960, Congress has had to address the debt ceiling or debt limit no less than 78 times.
So it feels a little bit "hashtag deja vu all over again" this time around. We've seen this story play out so many times in the past, and in each case, policy-makers have managed to get a deal done in some way, shape or form.
In the short run, it always leads to significant bouts of equity and fixed income market volatility. But the effects, thankfully, tend to be fairly short-lived, with typical measures of volatility quieting down in fairly short order and as this chart shows.
Even though debt ceiling debates typically run right up to the 11th hour, given the current dynamics in Washington, not only due to the narrow margin of control, but also because the parties themselves seem quite divided on how to resolve this, we actually think it might end up being more like 11:45 p.m. at night, which in our view is making the narrative a bit more unnerving for investors than in past debate cycles.
Our base case is we expect a deal to get done, but markets are starting to price in some concerns. It's especially pronounced in bond market volatility. While we've seen some settling in the backdrop since the banking industry stress initially materialized back in March, the MOVE index, or the bond market's equivalent of the VIX, is sitting nearly 80% higher than its ten year average.
As you can see in this chart, these concerns are also showing up in rising T-bill yields, with shorter term yields pushing well above longer term yields for maturities out through the end of July.
Even the differential between maturities pre and post June 1st are approximately 100 basis points. And we're only talking about two months. The three month to ten year maturity portion of the yield curve recently hit its most inverted level in 30 years, to the tune of -180 basis points.
Houston, the bond market is telling investors we have a problem. So we thought it might be helpful to game out some potential scenarios for investors as this flow chart attempts to show.
Our base case that a deal gets done and the debt ceiling is raised is at the top. We would expect the yield curve to steepen, volatility to partially subside, the equity market to come under pressure as budget cuts lower earnings expectations, core fixed income to outperform credit, and credit default swaps to basically revert back to historical levels.
In the case of a debt limit suspension or delayed decision, we think it likely creates a similar dynamic for markets and investors as our base case. But in this scenario, equity markets could actually stage a bit of a relief rally in the short run as the delay kicks the can down the road for budget cuts and policy-makers potentially find a way to raise the debt ceiling without curbing spending altogether.
That's really the notable difference between those two scenarios. In the scenarios where policy-makers do not manage to reach a decision and we go past the deadline, we do expect equities to come under significant pressure.
In our view, it could quickly translate into a material market correction of 20% or more downside in a matter of just a few days. At 17.5 times forward PE on the S&P 500, the market is not priced to absorb that kind of a shock. We'd also expect to see fairly sizable impacts on both treasuries and the US dollar.
While we continue to view a soft landing, aka a mild recession, as our base case for the US economy, a technical default or worse would likely exacerbate the situation, driving the US toward a much harder landing economic scenario.
It's always difficult to position portfolios for binary event driven outcomes like this one, but given the dynamics in play, we are still very focused on tactically de-risking portfolios, running a defensive playbook and buckling in for what we think will likely be a choppy summer.