‘It depends on how close we get to the brink’: Stock market turbulence likely as US heads for default, analysts say

By Joy Wiltermuth

Congress may only have until this summer to reach an agreement to remove or suspend the US federal debt ceiling, prompting analysts to warn of growing risks to global financial markets as America nears a potential default.

“It would do untold damage to financial markets,” Amar Reganti, a fixed income strategist at Hartford Funds, told MarketWatch. If a debt crisis is not averted and the government can no longer borrow to meet spending, “there is no part of modern capital markets that offers investor protection” if there is a significant US credit rating downgrade.

The US Treasury Department began “extraordinary measures” in January to keep the government on track with its bills after hitting its current debt ceiling of about $31.4 trillion. Since its inception a century ago, the US debt limit has placed limits on how much the federal government can borrow to meet existing commitments already approved by Congress.

The Congressional Budget Office on Wednesday estimated that the US government could reach its debt ceiling sometime between July and September.

See: CBO warns of possible US default between July and September as debt limit standoff continues

Reganti at Hartford Funds has had a front row seat on previous US debt disputes while serving as deputy director of the Office of Debt Management at the Treasury Department from 2011 to 2015.

Right now, the roughly $24 trillion Treasury market continues to hum as the deepest and most liquid market in the world. Reganti expects volatility to hit likely maturing Treasury bills in the coming months if Congress fails to reach agreement on the debt ceiling. But he sees catastrophe in markets if the US defaults because its debt is “hardwired” into the global financial infrastructure.

For these reasons, financial markets tend to dismiss the possibility of a US default as unthinkable and instead “rely on the fact that, historically, Congress has been reluctant to raise the debt limit,” Reganti said.

The stock market fell 15% in 2011

Uncertainty has generally not been a friend of the financial markets.

Congress has already raised the debt ceiling 86 times, including 18 times under former President Ronald Reagan, according to a balance sheet from Invesco. The economy was suffering from double-digit inflation at the time and the US Federal Reserve interest rate had peaked at almost 19%.

US inflation appears to have peaked at 9.1% last summer, while the Fed’s interest rate is expected to be above 5% this cycle.

A look at the 2011 debt ceiling shows that riskier assets sold off (see chart), with the S&P 500 index falling about 15% from July to September, but gold, US Treasuries and highly rated corporate bonds benefited from demand for “safe havens”. .

“What made 2011 so different,” said Brian Levitt, Invesco’s global market strategist, was that Republicans had a comfortable majority in the US House of Representatives, which allowed them to give the Obama administration significant returns in return for a 2011 increase future spending cuts wrestle down the debt ceiling.

That deal wasn’t finalized “by the 11th hour,” Levitt said, adding that the lack of a “red wave” for the Republican Party in the 2022 congressional election may put a new debt ceiling within reach. A debt limit bill would need 218 votes to pass the House, which is narrowly controlled by Republicans. Democrats now have 212 seats in the chamber and would need six Republicans to join them to pass legislation.

However, if the current stalemate persists, Levitt sees a similar sell-off in stocks from the 2011 period as likely. “It depends on how close we get to the abyss.”

Treasury returns, a buffer?

One caveat about the current debt ceiling standoff is that it is the first time in more than a decade that the higher Treasury yields now prevailing are offering investors a sizeable “risk-free” bond yield, while also helping to cushion the downside risk of equities sell off heavily.

The 2-year Treasury yield was 4.6% Thursday, while the 10-year Treasury yield was 3.8%, according to FactSet. That’s up from 1.3% and 1.7% last March respectively.

According to Shankar Narayanan, head of trade research at Quantitative Brokers, liquidity in the Treasury market has held up over the past three decades of congressional debt ceiling struggles.

“Apparent liquidity is unaffected,” Narayanan said, citing historical trading data for Treasury futures and cash markets signaling past resilience in U.S. Treasuries.

“This time is no different,” he said. “But let’s see how that translates into the actual event.”

–Additional reporting by Robert Schroeder

– Joy Wiltermuth

(ENDS) Dow Jones Newswires

2/18/23 0852ET

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