A look at the stocks surge today and one would get the impression that not only should the government shutdown be permanent (closing the Fed would have a vastly different result on the S&P), but that the debt ceiling is completely irrelevant and immaterial for risk assets. One would get a far different impression by looking at today's just concluded 4-Week Bill auction. Today's outlier rate on the just priced $35 billion in 4-week bills can be seen quite dramatically on the chart below, and is evidence that someone (or someones) is getting quite nervous ahead of the events in the next few weeks.
What is going on here and why the spike? Recall what we said a week ago in "Here Is How To Trade The Debt Ceiling Showdown."
... there is a simple pair trade for those who would like to position for a contentious debt ceiling fight with an ETA mid-October and skip the bipolar and HFT-dominated equity markets. Recall that in the summer of 2011 when the last big debt ceiling debacle loomed and resulted in a last minute outcome that also led to the downgrade of the US by a rating agency that has since sold out, rates of bills due just before the debt ceiling D-Date soared, while those sufficiently after the ceiling interval tightened. Well, the same trade is just as applicable this time.
Sell October 31 Bills versus 12 Month Bills
Supply dynamics and potential market concerns around a debt ceiling stand-off in Washington should push the 1M1Y bill curve flatter... The October 31 bills are likely the most vulnerable, and should cheapen significantly versus 12 month bills in a protracted fight.
One-month and three month bills are already trading close to zero, having briefly traded negative last week. With bill supply to remain flat heading into the end of October, suggesting that supply should keep bills yields across the curve under pressure. With bill yields largely beholden to supply dynamics, the greatest scope for further compression is in year bills, which are currently trading around 10bp. Given historical relationship between bills yields and bills outstanding, year bills are roughly 3bp rich to supply-implied fair value, while 3-month bills are about 3.5bp rich.
This trade may be difficult to put on in size until after quarter end due to dealers balance sheet constraints. But as noted above, we believe that the market will not begin to fully price the risk to front end bills until about two weeks before the end date. We expect the opportunity to remain available at for the first week of October.
Sure enough, today is the first day of the next quarter (window dressing is over), and the bond market, if not so much the stock market, has finally awakened that the government shutdown is merely an indication of just how contenuous the debt ceiling negotiation very likely ill be, and that it is increasingly likely that the X-Date of October 18 may come and go without a deal, which just may result in a technical default on the nearest maturity Bills.
End result: today's auction was an absolute abortion and absent some deus ex machina agreement between the GOP and Democrats, one can expect the October 31 bills (and others just around them) to continue blowing wider as quietly but confidently those holding the most at risk paper exit stage left.
But that's not all. We also noted the following:
The last go-round, the 1m1y curve flattened to 3bp. Though the curve is just 6bp away from that right now, it is beginning from a starting point that is 10bp flatter than one month prior to the 2011 debt ceiling. The securities that the market viewed as “at risk” traded with yields above year bills, hence our recommendation to sell the October 31 issue rather than the current one month bills.
We think that the curve has scope to flatten to zero, if not further, depending on how close to the wire negotiations come.
As of moments ago, the curve has gone beyond flat and into "further" as the 1M1Y just went negative.