US debt ceiling: how it could impact fixed income markets

We have seen this playbook numerous times before, with political posturing leading up to the point of brinkmanship before a last minute compromise on the US debt ceiling is agreed. The political backdrop to the current debt ceiling negotiation is shaky to say the least and an accidental default remains a key risk (albeit not our base case) given the uncertainty around the “X-date”, which is the day on which the US government runs out of borrowing capacity

History can be a useful guide and comparisons have been drawn to similar events in 2011, when the debt ceiling was raised with just two days to spare. The market reaction was linked to a severe loss of confidence, with US Treasuries rallying despite a loss of their AAA status, safe-haven currencies outperforming and credit spreads widening.

However, we need to be careful around making direct comparisons to this period - the market environment was very different back then. The eurozone was experiencing its own challenges at the same time with periphery spreads widening significantly leading to weakness in other cyclical assets.

This time, we’re nearing the end of the most aggressive rate hiking cycles seen for over 40 years and interest rates are already a lot higher. Equally, US activity data was also deteriorating sharply, making it more challenging to disentangle some of the market drivers at the time.

This time around we also have the additional headwind to growth from tighter credit conditions, following the recent turmoil in the US regional banking sector.

The market has so far been somewhat sanguine to current risks. T-Bills maturing around the expected X-date have cheapened significantly and US sovereign credit default swaps (CDS) are trading with a wider spread than in 2011, although this is not really a useful comparison in terms of default probability given the very different interest rate environment. Nevertheless, volatility across risk assets and currencies remain subdued, for now, consistent with the view that some markets are under-pricing these risks.

Broader reaction across markets tends to happen closer to the X-date

History shows that volatility rises closer to the X-date. Although the market is aware of this playbook, it might be that volatility rises earlier this time around. Based on our analysis we would see markets pricing in a more intensified cyclical slowdown, leading to credit widening. In other words, high yield underperforming investment grade, government bonds rallying and US dollar weakness, particularly versus defensive currencies like the Japanese yen.

It's worth noting though, that this time, the US Federal Reserve has much greater ammunition to cut interest rates, which might have different implications for curve shape. In 2011, the risk was around curve flattening.

Politics will determine the market playbook

It is likely that some period of extension will be given to allow for more meaningful negotiation. While this might provide a period of relief for markets, it won’t be the end of the story and uncertainty is likely to persist.

A hit to confidence contributes to slowing global growth and a period of disinflation, which is likely to put downward pressure on government bond yields. However, a more volatile market backdrop lends itself to more agile positioning and careful position sizing.