The next big economic data point on the agenda for markets is the May jobs report on Friday, June 2. The question is, will investors be able to look away from the debt ceiling saga in Washington long enough to even notice it?
As Executive Director for Applied Research, Qontigo’s Olivier d’Assier is responsible for generating unique insights into risk trends.
Think of interest rates as the rent investors pay for living in the market, and the Fed as their landlord. After spending most of 2021 assuring investors that rents would not rise in 2022, the central bank has raised rental costs by more than 500 basis points in absolute terms (from 0.08% in March 2022 to 5.08% today[1]). The choice for investors was ‘move out’ or try to ‘renegotiate’ the lease.
As it happens, some investors have opted to move out, indicated by the drop in average daily trading volumes in the past year[2]. Meanwhile, those who stayed are desperately trying to renegotiate their lease agreement with shorter terms. Gone are the days where investors readily signed up to multi-year tenancy agreements. At these rates and with an uncertain economic future, intensified by a continuously delayed global recession, most investors are living month to month. In other words, everything investors care about and can confidently predict is now far more short-term.
On the docket for the next few weeks is the potential of a first-ever US default, as the debt ceiling negotiations head into their final stretch, without a clear path to a deal. Of course, a US default would be the equivalent of Armageddon for global financial markets, not just the US. If this happens, the doomsayers predict US yields will surge, equity markets will plunge, housing bubbles will burst, credit spreads will swell for any bonds rated BBB or lower, economies will collapse (starting with emerging markets), commodity prices will become uncontrollably volatile, and currency markets will become unhinged. And that is just week one.
So why aren’t investors panicking yet?[3]
- First, we’ve been here before. Since 1960, the US government has tweaked the borrowing limit 78 times, in each case without triggering a default – one only has to cry wolf twice for others to believe nothing is coming!
- Second, lawmakers have their own clock, and without the eleventh hour, nothing in Washington would ever get done. No one knows precisely when this hour will arrive, but we do know that the first Treasury debt interest payment is due on June 15 – missing that would automatically trigger a technical default.
- Third, leaders of both parties have indicated that a default is off the table – probably because neither of them could hope to get re-elected if economic Armageddon happened on their watch.
- Fourth, predictions of the economy’s impending demise have been greatly exaggerated. Thus far, the economy has not only been resilient, but is actually bordering on defiant in the face of rising interest rates. The most anticipated recession in history is now the most postponed in history and may even be a no-show.
- Fifth, and probably the real reason markets are not panicked yet: trust is a relative game, not an absolute one. What other government are US-dollar investors going to trust more than the US itself? The reason markets haven’t reacted yet is much like Dorothy and her ruby slippers: there is no place like home, and nowhere else they would rather be. For now, to quote the late great Tina Turner, the US Treasury market is ‘Simply the Best’.
Conclusion
The first law of holes states that when you’re in one, stop digging. Allowing even a technical default would be the equivalent of using dynamite to try and blow yourself out of the hole. That never worked, not even for Wile E. Coyote. Although a default has never happened, the closest we came to one was in July 2011, and the credit downgrade by S&P from AAA to AA+ made then still stands today. Equity markets fell by 16% and took six months to recover. In a recent article, we analyzed what would happen to equity and multi-asset portfolios should a similar event unfold today.
As long as a default can be avoided, it seems that for bond investors, AA+ is the new AAA. For equity investors, this month at least, the message for Congress is reminiscent of another of Turner’s greatest hits: ‘Better Be Good to Me’.
[1] https://fred.stlouisfed.org/series/DFF
[2] See chart 27 on 20-day average trading value in the US Risk Monitor: https://stoxx.com/risk-monitors/united-states/
[3] The only sign of discomfort was seen in the market for ultrashort-term Treasury bills, which has seen particular volatility, with the yield on securities due on June 1 surging on Wednesday, May 24 to above 7.1% from 5.98% on Tuesday (WSJ).
