Not all risks to a portfolio have to be unseen market forces, or mathematical concepts born of complex financial engineering.
Some are very visible and plain for all to see.
One such risk is the near-and-present danger of the US ‘debt ceiling’ being hit, the so-called ‘x-date’ when the US Government must either raise the ceiling or enter default, where the Treasury cannot pay the country’s debt obligations.
The debt ceiling was introduced in the late 1930s, establishing a limit on total debt accrued by the government across all instruments. Since the 60s, the debt ceiling has been raised nearly 80 times, all without default.
The below chart from the BBC shows possibly the one thing that the US government reliably has agreed on across the aisle: they need to be able to run more debt.
Source: BBC
In December 2021, the debt limit was set at $31.4 trillion USD (a rise of $2.5 trillion form the current level) – in January this year, that level was hit, setting off this latest episode of panic. Below is the up-to-date estimate of total US national debt:
Source: US Debt Clock.org
Given how many times the ceiling has been raised in the past, what has caused the panic and consternation about this particular negotiation to raise the debt ceiling?
Like a few times in the past ~15 years, the nearing of the debt ceiling has prompted hostage negotiations between both major parties, with an element of mutually assured political destruction hanging over proceedings. The US saw two government shutdowns in 1995 and 1996 over the debt ceiling, a 2011 spat saw S&P downgrade the US national credit rating for the first time ever, and more recently there was a debt ceiling debate in 2013 over the Affordable Care Act under the Obama administration.
It stands to reason that no major party would benefit from having US Treasuries default, and stain the reputation of currently the world’s favourite risk-free collateral.
A default would mean markets would lose faith not only in US Treasuries, but also in the dollar which is needed to purchase them (we noted Treasuries as a key tenant of the USD’s reserve currency status a few weeks ago), credit spreads would widen and national spending would be hurt, which would eventually feed into equity earnings. As we said, a real-and-present risk to portfolios which is plain to see.
What are markets pricing?
A common way to see market panic is to examine very near-dated US Treasuries versus the risk-free rate (the Fed Funds rate) – if you suspect the government may default on its interest obligations in ~3 months, most prudent capital managers would not leave things to chance, and shift their USD investments into 1-month investments which mature ‘before the x-date’.
The result is that when investors panic about the money-goodness of the US government, 1-month T-Bills trade at a yield discount to Fed Funds:
Source: Bloomberg
Today there is a 1.26% yield-discount (which means the price of 1m T-Bills is higher), suggesting many investors who hold strategic USD reserves/assets are piling into these Treasuries which should mature before the US Treasury runs out of money.
Incidentally, how is the Treasury going for funding?
Source: Bloomberg
After declining to ~$86 billion in early April, the Treasury General Account (TGA) has received a $200 billion injection from healthy April tax receipts – pushing out the date at which they no longer have the liquid capital to fund their debt obligations.
This fact is apparently not appreciated by markets however, which continue to price higher-and-higher insurance premium for US national debt: the chart below shows the historic levels of premium on 1-year credit default swaps for the US.
Source: Bloomberg
Implications for Markets and Portfolios
The debt ceiling presents an interesting challenge, not necessarily for long-term investors, but certainly for those who operate tactically or are seeking to speculate on the situation.
If the US does default on its debt, we have outlined the likely results; US Treasury yields explode higher (prices fall, capital loss), the USD declines, equity markets likely decline in the uncertainty and then with the impact this has to national growth and credit availability.
But what happens when the debt ceiling issue is resolved?
One topic which several institutional asset managers have already flagged is the withdrawal of liquidity from the market this would cause – the TGA will need to be replenished back to its usual $300-400 billion levels, and so around $300 – 350 billion will likely get vacuumed out of the market. The below chart gives some indication of what might happen if that level of liquidity is pulled out of the system:
Source: Innova Asset Management, FRED
Whilst this is not a guaranteed outcome, there’s a very real possibility that this turns into a ‘heads you lose, tails you lose’ scenario for the unprepared investor.
We place a very low probability on the US defaulting on its debt obligations over some political negotiations – incentive schemes are such that no politician in power today will have a pleasant time being seen at the helm of the first (intentional) default of US national debt.
But in the event this visible risk does come to pass, astute investors will have had ample time to position in a robust, risk-conscious manner which will weather any volatility storm far better than those who take short-term punts on an uncertain outcome.
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