The Big Debt Bet

HIGHLIGHTS:

• The US debt ceiling debate continues to cause volatility in the markets as political gridlock and partisanship remains.
• Kinks in the yield curve are appearing as investors wager on the debt limit and future creditworthiness of certain bonds..
• In 2011, when credit agencies downgraded the US government, financial markets felt the impact with stocks declining double-digits.
• Investors should remain cautious as downside risk outweighs the upside in the current environment.

Investors may be experiencing déjà vu as the debt ceiling debate yet again trickles through the political landscape and financial markets. US Treasury Secretary Janet Yellen warned Congress that the federal government may run out of money at the beginning of June, which could result in “economic and financial catastrophe.” Lawmakers are now debating potential government cuts and spending measures, which are typically tied to raising the debt limit. However, the Biden Administration wants Congress to raise the $31.4 trillion debt ceiling without any stipulations, saying the spending negotiations can occur afterward. The debt limit has been raised or revised 78 times since 1960, with lawmakers occasionally bargaining down to the wire. While the US government has never defaulted, simply delaying the resolution can have consequences.

In 2011, the US was going through another debt ceiling crisis, and then-House Speaker John Boehner expended considerable political capital to get a deal done between the Republican-controlled House and the Democratic White House. The result was a last-minute deal that avoided a US default. However, because partisan arguments allowed the US government to get so close to its default deadline, credit rating agencies took action. Most notably, in August 2011, S&P downgraded the US government’s rating from AAA to AA+. A lower credit score for—arguably—one of the world’s safest securities had far-reaching implications for investors and financial markets. In the last few weeks of July 2011, the Dow Jones Industrial Average fell over 1,900 points amid the debt debate and credit downgrade. Conversely, despite the aversion to US debt, bond markets rose over the same time period as investors sought out safe-haven assets.

Currently, we are already seeing bond investors react to the policy debate, with the short end of the Treasury curve moving fairly haphazardly. Investors are also betting heavily on an increase in stock volatility as any probability of the debt ceiling not being extended over zero is likely considered too high. Do we believe a deal will happen?

The short answer is yes. However, only time will tell who will win this game of chicken over the US economy and faith in the solvency of the US government. The most likely outcome is another short-term extension of the debt ceiling, potentially including some spending stipulations. However, there is also a slim chance policymakers will sacrifice the US economy and many livelihoods for political gain. That worry is combined with current anxieties over the probability of a mild recession, higher borrowing costs, inflation, and others. For now, investors should remain cautious as downside risks outweigh the upside in the current environment.

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