Stockwatch: why crunch day for US debt ceiling is so critical for investors

Threat of a US default continues to have a powerfully negative effect on global stock markets, and the clock is ticking. Analyst Edmond Jackson gives his view on the debt crisis and notes heavy buying of equities by the ‘Big Short’ investor.

Friday 26 May is an alleged crunch day to reach agreement on raising the ceiling on $31.4 trillion (£25 trillion) of US public debt, if there is going to be time for US government machinery and President Joe Biden to sign off a deal before the 1 June deadline.  

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Otherwise, the US could be out of funds to pay welfare and other obligations such as interest on some debt securities. The White House Council of Economic Advisers (CEA) has estimated an economic hit of over 6% due to a lower dollar hitting import purchasing power, and a likely recession. The US would lose its AAA credit rating and much sense of dollar assets being a “safe haven”. 

Similar crises in 2011 and 2013 were resolved at the eleventh hour, although this time around a unique set of circumstances makes “going to the wire” trickier. The US Senate is out of session and the House of Representatives faces a weekend recess for a Memorial Day on Monday, so would need recalling. 

Investors should at least be steeled for the US to technically default in a week’s time, and possibly moving to a situation where some welfare payments and interest on debt securities get compromised, before the ceiling finally gets raised. 

Even if a major short-term crisis is averted or managed through, events would be a reminder of how US public debt groans under the legacy of Covid stimulus payments and the Biden administration’s welfare commitments. Question is how to manage it in the longer run.  

Markets are – so far - fretting less than in 2011  

US equities plunged nearly 20% in August 2011 compared with a sideways trend in recent months. Yes, yields on short-dated Treasury bonds have risen quite sharply this week, albeit the benchmark 10-year Treasury is up only from 3.7% to 3.8% - as if only a modest nod of sympathy, while still expecting a deal to happen. 

The stand-off between Republican and Democrat Congressmen essentially arises because the left seeks to sustain welfare payments, while the right wants conditions attached. Republicans have demanded public spending cuts of up to $100 billion and insist that citizens in receipt of benefits should be actively seeking work. Democrats oppose this, given it would undermine spending commitments approved by the Biden administration ahead of the November 2024 Presidential election.  

But if they can agree, Congress could potentially vote on Tuesday 30 May if the House of Representatives is called back into session. 

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Mind how equities could sell off next week if Washington fails to raise the ceiling by 1 June and the US enters a situation where it starts missing financial obligations. Some analysts reckon it could have only $10 billion available on 2 June and $2 billion on 9 June. 

Higher interest rates are predicted in response to any reduction in the US credit rating, although it was cut in the 2011 debt ceiling crisis and rates actually fell as bonds rallied. 

The eurozone debt crisis did however provide a context of capital flight to safety in the US. This time around could be different as rates are now higher, and the US is fighting inflation. 

What is also different 12 years later is international debt levels being higher as a percentage of GDP, hence if the US credit rating falls, then most public debt may need re-pricing for risk. 

Political motivations look critical to achieving a deal 

A recent CNN poll finds 60% of US voters endorsing spending cuts as part of raising the debt ceiling, which is emboldening congressional Republicans not to capitulate.  

Landing space for a deal is thus difficult to define versus the 2011 and 2013 debt ceiling crises. Talks have begun later and lack a mutual sense of agreement on deficit reduction. 

Janet Yellen, ex-governor of the Federal Reserve and nowadays US Treasury Secretary, has said that moving in June to a managed situation of meeting some debt obligations but missing others would be “default by another name”.  

There is also a possibility of IT disruption given government systems are not state-of-the-art (witness the chaos when the Obamacare website launched a decade ago) and the situation would be unprecedented. If interest is not paid on only a few US Treasuries, it would raise fear. 

Fitch hints at downgrading AAA US credit rating 

This appears to have been a mid-week trigger behind US equities falling, although specifically is only a hint that the US is being “put on negative watch.” 

Fitch did the same in October 2013, two days before the government would have run out of cash.  

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There is quite some precedent for such, however. Standard & Poor’s downgraded to AA+ in August 2011 after Congress voted to raisethe debt ceiling, attaching a negative outlook. This was significantly driven by weaker effectiveness and predictability of US government. 

Global stock markets plunged, US indices by five to seven percent in a day. Yet ironically, and showing how hard it can be to predict markets over this matter, US Treasuries which had been the subject of the downgrade actually rallied, as did the dollar.  

Raising risk of stagflationary debt crisis 

This to me is the chief negative scenario affecting financial assets. 

If the US defaults and a measure of chaos ensues with interest rates rising, it would happen amid “stagflation” concerns.  

Inflation is proving sticky to bring down as wage rises get embedded, and central banks have only the blunt weapon of interest rates – where we will not see the true effect of recent rises until later this year and into 2024. 

If the US dollar and financial assets get hit, remember the US (as yet) represents around 60% of global equity markets; hence international pension fund values would also fall. 

Not to cast myself as Dr Doom, but I think we at least need to be aware of possible scenarios. For those with spare cash, it could set up an exceptional buying opportunity. 

Breakthrough in days ahead will likely prompt rebound 

One compromise might be for Congress to pass a short-term increase in the debt limit to allow more time for an agreement. 

An optimistic scenario sees the US government rely on recent quarterly tax bill payments until 15 June, which reduces the odds of a technical default when a near $300 billion debt payment is due. 

Investment professionals appear broadly on the fence, and I have not noticed any firm public calls either way. 

Yet it is interesting how disclosures by Michael Burry (pictured) – one of the first traders to predict and benefit from the 2007 to 2010 US subprime mortgage crisis – show he has been buying equities lately, in full awareness of the debt ceiling risks. 

He has gone from a broadly cash position to around $100 million worth of equities, and they are not cautious: financials constitute around a third of his holdings, mainly hard-hit US regional banks, then consumer discretionary and energy. It implies he believes talk of recession is overdone hence is positioning for rebounds.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.