Stock market investors have seen this movie before and are betting that the latest installment in the debt ceiling drama won’t introduce an unwelcome plot twist.
The calm “reflects a pretty strong belief that a solution will be found before the US defaults,” David Lefkowitz, head of equities for the Americas at UBS Global Wealth Management, said in a phone interview.
Risky handling of the federal debt limit has roiled parts of the US Treasury market and pushed the cost of insuring US government debt against default to record highs, but so far there has been little sign that a standoff that remains unresolved is causing stock market investors to frown Losing sleep could see the federal government default by early next month.
A default is widely described as potentially catastrophic, but investor fatigue is understandable. According to the Treasury Department, Congress has voted to permanently raise, temporarily extend, or revise the definition of the debt limit 78 times since 1960.
In January, the US government hit the $31.4 trillion debt ceiling, prompting the Treasury Department to take special measures to manage public finances. Treasury Secretary Janet Yellen has warned that those measures could be exhausted as early as June 1, potentially leading to the first ever sovereign default.
Congressional Republicans have insisted that any increase in the debt ceiling should be accompanied by sweeping spending cuts, while President Joe Biden and Congressional Democrats have called for a “clean” increase. Biden and congressional leaders met late Monday for the first time in weeks but failed to make any breakthroughs.
See: Biden describes the debt ceiling meeting as “productive,” but McCarthy says he “didn’t see any new movement.”
The S&P 500
SPX
was practically flat on Wednesday while the Dow Jones Industrial Average
DJIA
fell 210 points, or 0.6%, and the Nasdaq Composite
COMP
up 0.6%.
At the same time, there has been greater volatility in short-dated Treasury bills, which are typically a sleepy corner of financial markets, with the one-month instrument’s yield rising above the Fed Funds rate, which ranges from 5% to 5.25%. .
Implementation of the bill signals a reluctance to hold debt that could face a potential default as early as June 1 if the standoff is not resolved.
And the cost of insuring US Treasury bonds against default using instruments known as credit default swaps, or CDS, continued to rise. According to S&P Global Market Intelligence, the cost of insuring US debt against default for a year hit a record Tuesday, surpassing the cost of insuring Mexican and Brazilian debt.
See: The cost of insuring against US Treasury defaults hits a record high
It is the 1 month T bill
TMUBMUSD01M
Investors should monitor, Nicholas Colas, co-founder of DataTrek Research, said in a statement Tuesday. That’s because, unlike credit default swaps, the T-Bill market is very liquid and prices are available in real-time.
Colas has called 1-month T-bills “the most important asset in the world right now” and continues to reflect a “non-zero” chance of a technical default on US government debt.
“As we get closer to the June 1 deadline set by Secretary of State Yellen, we will see how the 1-month trade unfolds. Equity markets have so far shrugged off any concerns on the subject, but that could change if 1-month Treasuries push higher,” he wrote.
Some past showdowns have been accompanied by significant stock market volatility. And some observers fear a resolution may not materialize until there is a significant stock market downturn or other financial turmoil that would unnerve politicians into making a deal.
Read: Why it might take a ‘stock market crisis’ to break the debt ceiling standoff
Indeed, one risk for financial markets is that the Treasury Department and the Federal Reserve “stoke the fire further by publicly emphasizing the risks to the market and economy, rather than offering their usual measured reassurance in times of stress,” warned John Lynch, chief investment officer at Comerica Wealth Management, in a note. That would likely shake public confidence and “prompt a negative reaction from financial markets,” he warned.
In the meantime, investors may be remembering the debt ceiling disputes of 2011 and 2013, which were accompanied by volatility in stock markets. However, investors must also keep in mind the macroeconomic background that accompanied these episodes.
The S&P 500 plummeted in 2011 amid a debt ceiling showdown that left the US mere days from a possible default and saw the country’s AAA credit rating downgraded. But investors should remember the macro backdrop, UBS’s Lefkowitz said, noting that the sell-off in stock markets happened as the euro-zone debt crisis was deepening at the time. While the S&P 500 fell 17% from peak to trough, European banks fell 25%.
“I think it’s telling that if the center of the storm really was the debt ceiling, one would assume that US assets would be the hardest hit,” Lefkowitz said. “The bottom line was that it was difficult to distinguish what was the debt ceiling component and what was the eurozone debt crisis component.”
And in 2013, amid a global economic recovery, the S&P 500 index rose 30% for the calendar year and suffered a maximum loss of just 6%.
So what does the current macro backdrop say about the potential of the debt crisis to undercut equities?
There are concerns that the aggressive pace of the Fed’s rate hikes over the past year could trigger a recession, with the slowdown possibly exacerbated by tighter credit conditions following troubles at US regional banks, but the economy has appeared relatively resilient so far.
Investors who fear a default, which could be highly disruptive, can certainly protect themselves by selling shares or hedging positions, but UBS expects the debt ceiling to be raised, Lefkowitz said.
“I don’t think it really changes anything,” he said. Any volatility resulting from the standoff would likely be “relatively short-lived and relatively modest in the scheme of things.”
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