Goldman with many of the same points I made yesterday.
- More detailed information on US tax receipts is soon likely to provide a clearer view of when the US debt limit might become binding. Preliminary data suggest an increased probability that the debt limit deadline could be reached as early as the first half of June. While an early deadline would raise the possibility of an
extension, it also threatens to bring the issue into focus more quickly. - Our central expectation is that the debt limit will be raised ahead of the deadline, as it has been in the past. But the risks of failure to reach an agreement are the highest that they have been since at least 2011. We see value in looking for potential hedges against that outcome, particularly since our baseline views otherwise envisage lower US recession probabilities and a smaller chance of Fed easing than the market is currently pricing.
- We think the risks from a debt ceiling crisis are more likely to present as a large but temporary shock to US growth expectations, as non-interest payments would be eliminated if a deal is not reached in time, rather than as fears of actual default. This is similar to 2011, though we think the more persistent growth risks from fiscal tightening that we saw in the 2011 debt limit deal are less likely now. Two approaches suggest that this could generate sharp declines in credit, equities and bond yields, alongside a spike in (equity) volatility.
- In choosing hedges, investors should take account of the potential uncertainty over the timing of a debt ceiling scare, the less favorable entry points for further declines in Treasury yields and curve steepening, and the potential need to monetize hedges quickly given that any shock may be short-lived. Downside in US equity and credit indices and upside in US equity volatility screen relatively well across these criteria. Hedges that focus on joint outcomes may increase leverage, although correlation pricing is less favorable in general than it was before the banking turmoil.
The first exercise simply assumes that the shifts we would see in markets around a debt ceiling crisis this year would mirror what we saw in 2011. The challenge here is that the European sovereign crisis was in full swing in the summer of 2011, the US growth backdrop was weaker than it is now, and significant Fed policy shifts were also on the horizon, so it is hard to be confident that shifts over that period can be fully attributed to the debt ceiling worries. To mitigate that risk, we think it makes sense to focus on are latively narrow window (from July 22 to August 10), in which US dynamics appear to have been the primary driver (as suggested by Exhibit 1) and over which measures of European sovereign risk were relatively stable.
