IAUM - U.S. Debt Standoff To Add To Volatility

2023-05-15 10:35:00 ET

Summary

• We think the U.S. debt limit showdown will spark renewed volatility in markets. That risk reinforces why we stay invested and cautious by going up in quality.
• Stocks were flat last week after U.S. data confirmed core inflation staying high. We think sticky inflation makes Federal Reserve rate cuts later this year unlikely.
• U.S. industrial production and business survey data due this week should gauge how the Fed’s rate hikes have hurt industrial and business activity.

Transcript

The U.S. Treasury hit the debt ceiling in January and is nearing the June date when it may be unable to pay its bills on time.

We think the U.S. debt showdown will stoke volatility in financial markets.

Here’s why:

1) Volatile economic regime

The U.S. faced a similar standoff in 2011 amid the euro area debt crisis. Back then, policy rates were near zero, deflation risks were emerging, and the Fed’s balance sheet was expanding. Today, the backdrop is very different.

Bond market volatility has surpassed the 2011 level as markets grapple with central banks’ trade-off to live with some inflation or crush economic activity.

Equity volatility is more muted, but we don’t think stocks are immune - just a few major tech firms drove almost all of this year’s S&P 500 returns.

2) Technical default and credit rating risks

If the debt limit isn’t raised or briefly suspended, the Treasury would be forced to miss payments, even if it prioritized paying bondholders. Credit rating agencies would likely lower the U.S. credit rating like S&P did in 2011.

3) Cautious but eyeing opportunities

We have been positioned defensively as the Fed rapidly hiked interest rates, creating financial cracks.

We stay cautious and prefer quality within stocks and bonds. And we’re ready to nimbly shift our six- to 12-month views to seize opportunities if risk assets better price in the economic damage we expect.

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Negotiations to lift the U.S. debt ceiling are heating up. The Treasury hit the $31.4 trillion “ceiling,” or cap on how much debt it can issue, in January. It may be unable to pay its bills in early June. Even if a deal is struck before then, we expect the debt showdown to stoke market volatility. The bigger story on a six- to 12-month horizon: we think central banks must damage growth to cool inflation in the new regime. We stay invested but cautious as a result, and favor quality assets.

Volatility brews

Notes: The chart shows the normalized level of implied volatility for U.S. Treasuries and the S&P 500 in standard deviations as of May 5, 2023. The MOVE index represents U.S. Treasuries implied volatility, while the VIX index represents S&P 500 implied volatility.

A delay in lifting the U.S. debt limit, as well as the euro area debt crisis, spurred a bout of market volatility in 2011. See the chart. U.S. Treasury bill yields seen as the most vulnerable to late payment jumped, and the S&P 500 fell about 17% between July and August 2011. Policy rates were near zero back then, deflation risks were emerging and the Fed balance sheet was expanding. All that provided a cushion. The backdrop is very different today. Bond market volatility has already surpassed the 2011 level (dark orange line) as markets grapple with central banks’ trade-off: either live with some inflation or crush economic activity. Equity volatility is more muted (yellow line). Yet, we don’t think stocks have been immune - just a few major tech stocks account for almost all S&P 500 returns this year. Our conclusion: Brace for higher volatility because of the combined effect of debt ceiling concerns and financial cracks from rate hikes.

Invested but cautious

It’s uncertain when exactly the U.S. Treasury will run out of funds to meet its financial obligations - known as the “X date.” Treasury Secretary Janet Yellen has warned that could happen as soon as early June. Conversations about a last-minute deal to raise or suspend the debt ceiling, meaning eliminate it for a brief period, are ongoing as Democrats have so far rebuffed Republicans’ push for spending cuts and other concessions. The Treasury risks a technical default when it temporarily fails to make its bond payments if policymakers don’t strike a deal in time. The Treasury may prioritize paying bondholders over others, but it’s unclear if the Treasury can do so: there is no precedent, and the Treasury lacks the legal authority. Yet, there is precedent for credit rating agencies trimming the U.S. top-notch credit rating like S&P did in 2011 - even if a technical default doesn’t happen. That could cause investors to demand more compensation for holding U.S. assets amid higher risk.

Yields for some Treasury bills maturing just after the X date have already started to rise, but risk assets have yet to fully react. Yields for the affected Treasury bills could march higher, and volatility may keep cycling through assets if the debt ceiling is repeatedly suspended.

We stay invested but cautious against this backdrop. We had already been going up in quality and focused on building resilient portfolios as the Fed rapidly hiked rates. We see opportunities to earn attractive income in short-term debt if yields rise more. Investors who don’t need to quickly sell assets can earn attractive income during the debt showdown, in our view, by holding on to at-risk Treasury bills until they mature. Persistent inflation makes inflation-linked bonds attractive, too. Notably, demand for gold has picked up via exchange-traded funds and foreign exchange reserve managers.

Developed market equities remain the bulk of portfolio allocations, even as we underweight them slightly in the short term. We prefer emerging market ((EM)) stocks in the short term, as they benefit from China’s economic restart, EM central banks nearing the end of their hiking cycles and a broadly weaker U.S. dollar. We could consider leaning more into equities overall if debt ceiling volatility and recession create a sharp fall in equity prices.

Our bottom line

The debt ceiling showdown is set to increase the volatility in financial markets that has defined the new regime. Any selloff may cause risk assets to better price in the economic damage we expect from interest rate hikes. We’re ready to shift our views on a six- to 12-month horizon to take advantage of opportunities that may appear.

Market backdrop

Global stocks were largely unchanged last week, and bond yields stayed within their range since mid-March. U.S. CPI data showed that core services inflation, excluding shelter, is easing, but core goods prices surprisingly ticked higher. Core inflation still doesn’t look on track to settle near the Fed’s 2% target, making Fed rate cuts this year unlikely, in our view. The Bank of England hiked policy rates to 4.5% as it carries on with its fight against stubborn inflation while growth stagnates.

We’re watching industrial production and business survey data in the U.S. to gauge the damage to activity as higher interest rates tighten financial conditions and cause financial cracks, as seen in bank turmoil. We’re also looking for signs of a sustained rise in Japan inflation that we think may eventually spur a change in ultra-loose policy - and bond volatility.

This post originally appeared on the iShares Market Insights.

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