US Treasury Secretary Yellen qualified her forecast with a reference to the federal government’s variable cash flow and warned that the precise date on which Treasury would be unable to pay the government’s bills could be weeks beyond her current estimate. She also encouraged Congress to raise the debt ceiling promptly to avoid a default and a subsequent erosion in the credit quality of US government securities.
The ambiguity of Yellen’s forecast, together with the abbreviated time frame for negotiations between the president and Congress, was an unexpected development, in our view. The uncertainty regarding the X-Date is attributable to conflicting data. Treasury expects to receive a surge in receipts from quarterly estimated tax payments on 15 June but is also burning through cash relatively quickly. Secretary Yellen did affirm her intent to provide additional market updates as better data becomes available.
The Congressional Budget Office (CBO) also revised its own forecast in conjunction with Secretary Yellen’s announcement earlier this week. The CBO had estimated that Treasury would exhaust its ability to use extraordinary measures at some point between late July and September. Their new estimate, which is largely in line with the Treasury Department’s, is attributable to lower-than-expected income tax receipts through 18 April and faster processing by the Internal Revenue Service (which reduces the recognition of revenue in May).
Market reaction
The proximity of the probable X-Date caught market participants by surprise and has added a degree of volatility to the government bond market, in our view. Not surprisingly, the short-term Treasury market reacted to the prospect that a resolution may not be reached until the 11th hour. Bid-ask spreads widened, and yields have increased abruptly at the short end of the curve, which is more exposed to the uncertainty of a potential default. The 30 May to 13 June T-bill spread rose by 50 basis points in the wake of Secretary Yellen’s announcement.
Equity investors have not reacted with the same degree of concern as fixed income investors. As the earning season has unfolded, companies have performed better than anticipated with improvements in the breadth and magnitude of earnings “beats” relative to the last two reporting seasons. For additional context, equity market valuations remain somewhat lofty and expected volatility is also not registering any warning signs, underscoring our view that we don’t think the debt ceiling angst has had an impact yet on equity markets.
However, as the month progresses, we believe it’s reasonable to expect wider credit spreads, elevated risk premiums, lower equity prices and a depreciation in the value of the US dollar. While we still believe that Congress will raise the debt ceiling again, as it has on 89 previous occasions since 1959, this year’s debate appears particularly contentious.
If the debt ceiling negotiations do go down to the wire in the coming weeks, which seems likely, there could be some minor equity market volatility. But for the time being, market participants are more focused on the price volatility of regional banks.
An outright default would be a more disruptive event that could spark a sharp sell-off in stock prices. Because a default would be unprecedented, the magnitude of the market decline is difficult to estimate, but we would expect it to be very meaningful.
What should investors do?
The ultimate resolution to the debt ceiling fight in 2011 involved the enactment of the Budget Control Act, which suppressed discretionary spending. A resolution that incorporates mandatory spending cuts would compound the economic impact of an exceptionally tight monetary policy. Credit conditions are already tight in the wake of regional bank failures and the pace of economic expansion is slowing. We believe that any delays in government transfer payments could trigger a loss of consumer confidence, demand destruction, and economic contraction.
While short-term yields have remained elevated, yields on longer-dated securities are more likely to decline, as portfolio managers reposition portfolios in anticipation of a more lenient monetary policy by the Fed. For those investors using a barbell strategy for their fixed income investments, a modest pivot to towards longer dated bonds would be appropriate, in our view.
For US investors, we think longer-dated tax-exempt municipal bonds have the potential to outperform corporate bonds. Munis are generally more insulated from the market volatility that imperils the total return available on corporate bonds, so spread widening at the state and local government level should be more constrained. Gold should perform well in the near-term, as it has in the past during debt ceiling stalemates. An actual default, while still unlikely, should undermine the value of the dollar (USD). To position for a weaker dollar, investors should diversify their dollar cash or fixed income holdings, reduce allocations to US equities, hedge outright, or position in options or structured strategies that could deliver positive returns in the event of dollar weakness.
We retain an underweight in US equities, and the debt ceiling stalemate has done little to alter our view. We remain least preferred on US financials. Cyclical sectors are particularly vulnerable if a default starts to look more likely. Investors who find market volatility particularly unpalatable may want to consider repositioning their portfolios with a higher weighting towards defensive sectors.
Main contributors: Solita Marcelli, Thomas McLoughlin
Content is a product of the Chief Investment Office (CIO).
Original report - Debt ceiling deadlines , 8 May 2023.
