U.S. debt ceiling needs to be raised
By Volker Schmidt, Senior Portfolio Manager at Ethenea
This year, investors could experience an unexpected déjà-vu of the 2011 US debt crisis. Normally, financial markets do not handle uncertainty well. However, so far only the CDS market is jittery.
On 19 January, the U.S. Congress received an unusual letter. Sent by U.S. Secretary of the Treasury Janet L. Yellen, it warned the floor leaders of the two chambers of Congress that the debt limit of around USD 31.4 trillion would be reached that very day. Yellen also announced that the “extraordinary measures” undertaken by Treasury meant that investment in pension funds for postal service and civil service retirees would have to be suspended. If Congress did not act swiftly to re-raise the debt ceiling, the largest issuer of bonds in the world could be facing insolvency in the summer.
Although the debt limit has already been increased 79 times in U.S. history and more than ten times since 2010 by bi-partisan majorities, 2011 in particular remains a painful reminder to market participants of the deadlock over the debt limit. Representatives only reached agreement two days before the deadline on 2 August.
As far as the economic environment is concerned, the impact on consumers and investors was palpable in 2011. Consumer and company confidence fell dramatically; the S&P 500 equity index fell 17% in the two weeks around the deadline, while share price and credit spread volatility rose sharply and remained high for a long time. Yields on the Treasury papers that matured around the time of the deadline dipped steeply, as did other money market instruments, while some Treasury securities were no longer accepted as collateral for derivative transactions. Higher default risks dampened demand for short-term U.S. Treasuries among foreign investors, and the U.S. dollar lost 9.2% against the euro between the beginning of 2011 and the time the problem was resolved.
Safe sovereign bonds ?
Nobody knows whether we will have a repeat of 2011 this year. But given that the U.S. economy is weakening, one other negative factor, such as protracted negotiations over the debt limit, could tip the balance towards recession. The U.S. economy is on a flat growth trajectory, not least due to strong consumer spending. Should anything go awry and American consumers hold back on spending, there is a chance of deep recession.
In 2011, however, there was one unlikely winner and that was long-term U.S. Treasuries, as investors bought them up en masse in the two weeks before the deadline. As a result, the 10-year yield fell from 3% to 2%. Although the risk of sovereign default was greater than ever before, investors paradoxically saw long-dated debt instruments issued by the U.S. government as a safe haven, as the dollar was still the global leading key currency and the U.S. government had a theoretically unlimited capacity to issue money, to which it ultimately would have resorted. If we end up this year with a showdown like in 2011, investors will favour safe sovereign bonds for the same reasons, and drive yields back down.
In the Credit Default Swap (CDS) market, the risk of a repeat of 2011 is already being assessed as very high. CDS spreads, which reflect the cost of hedging U.S. debt, have risen to levels similar to 2011.
Enough cash until the beginning of June
The U.S. equity market meanwhile is continuing to recover from the previous year’s falls, with no sign of any panic. Consumers, too, are relaxed and spending remains buoyant despite the forthcoming political wrangling. Given the history, they are confident that agreement on a new higher limit will be reached. The media is focused on other issues, and Americans have other concerns. However, that could change as the deadline approaches, especially if the subject of debt is mentioned more and more in the media.
According to Treasury Secretary Yellen, the cash balance held at the U.S. Treasury (currently around USD 400 billion) and current tax receipts will be enough to make all the necessary payments up to around the beginning of June. Congress has until then to reach a compromise to avoid default. Congress still has time to settle its political differences of opinion – and, as history shows, U.S. politicians tend to bury the hatchet sooner or later – and avoid the aforementioned doomsday scenario if the whole country is facing bankruptcy.
Normally, financial markets do not handle uncertainty well. However, so far only the CDS market is jittery. Given the reputation that CDS traders have as gamblers, the public is otherwise unperturbed. The sooner the politicians agree, the easier it will be for the economy and for investors’ nerves. All of us – apart from speculators in the CDS market – could do without the rollercoaster ride like in 2011. The sooner a new debt limit is agreed, the better.
