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US Debt-Ceiling Standoff: High alert in bond market but equity investors don’t seem to care

The debt-ceiling standoff in Congress has the US at risk of being unable to pay its bills as soon as June 1.

US debt-ceiling, market, investors, risk, equity, economy, recession
The US economy is potentially approaching a recession after the Federal Reserve’s most aggressive monetary tightening campaign in a generation.

Bloomberg: The debt-ceiling standoff in Congress has the US at risk of being unable to pay its bills as soon as June 1. You’d think stock-market investors would be anxious about the uncertainty — but you’d be wrong. While hedging activity is picking up on the fringes, there are few signs of panic. Expectations for price swings in stocks most sensitive to a government default still hover near a two-year low. The S&P 500 Index slid 0.3% this week and the Nasdaq 100 Index rallied 0.6%. And a measure of market risk, the Cboe Volatility Index, or VIX, dipped back to near a 17 level.

Make no mistake, the risk is real. Treasury Secretary Janet Yellen said Friday that the US will “have to default on some obligation” if Congress doesn’t raise the debt limit. It’s just equity investors don’t seem to care.

The uncertainty around the debt ceiling is “like kicking a man when he’s already down,” said Adam Phillips, managing director of portfolio strategy at EP Wealth Advisors. “Depending on what happens with the debt ceiling, we could see additional fiscal drag in addition to monetary policy. That will eventually need to be reflected in stock valuations because it’s not showing up yet.”

In the bond market, investors are on high alert. The cost of credit-default swaps insuring Treasuries against default is higher than contracts on the bonds of countries like Greece and Brazil.

But things are more complacent in the stock market. A basket of companies compiled by Citigroup whose sales rely the most on the government — including aerospace and defense firms like Boeing Co. and Raytheon Technologies Corp. — has declined 1.8% this month, not too far from the S&P 500’s 0.9% loss.

Meanwhile, a gauge of projected price swings in the iShares U.S. Aerospace & Defense ETF and the SPDR Aerospace & Defense ETF in the next 30 and 90 days is hovering in the bottom quartile of its two-year observations, data compiled by Citigroup strategists including Scott Chronert show.

Still, some market veterans warn it may be the calm before a storm. And since protection against a massive drop is cheap, people are taking precautions against the unthinkable, pushing the relative cost for put options last week to the highest in a year.

In 2011 the government narrowly made a deadline for raising the debt ceiling, resulting in the first US credit-rating downgrade. Just like now, the VIX remained sanguine as the escalation of the debt ceiling drama sent credit default swaps spiking. But the VIX quickly jumped to 48 when Standard & Poor’s stripped the US of its AAA credit rating.

Back then, the S&P 500 didn’t bottom until two months after the debt-ceiling agreement was struck.

A confluence of factors from a European debt crisis to a US credit downgrade turned the 2011 debt-ceiling impasse into a full-fledged rout. That isn’t a risk now, but this market is facing its own set of challenges.

The US economy is potentially approaching a recession after the Federal Reserve’s most aggressive monetary tightening campaign in a generation. And a crisis in the banking system is still simmering. Meanwhile, at 18.1 times profits, the S&P 500 is trading at a valuation multiple that’s above its average over the past 10 years.

Should valuations moderate and fall, the dip may open a buying opportunity, assuming a debt-ceiling compromise is reached, BMO Wealth Management’s Yung-Yu Ma and Citigroup’s Chronert say.

“The real risk here is not exactly the default in and of itself and the financial ramifications, it’s what it does further to strike at and erode, crack, or break ultimate consumer confidence and economic spirits,” said Matthew Benkendorf, CIO of Vontobel’s Quality Growth Boutique. “The uncertainty and anxiety leading up to it is going to further exacerbate what is going on in the banking system and unwillingness to lend credit.”

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First published on: 14-05-2023 at 19:19 IST