US Sovereign credit risk protection has never cost so much as it currently does...
...but Goldman Sachs' Dominic Wilson believes that systemic risk threat is overdone:
We think the risks from a debt ceiling crisis are more likely to present as a large but temporary shock to US growth expectations, as non-interest payments would be eliminated if a deal is not reached in time, rather than as fears of actual default.
While their central expectation is that lawmakers reach some compromise before the X-date, Goldman does warn that the risks of failure to reach an agreement are the highest that they have been since at least 2011.
Wilson notes that the more persistent growth risks from the fiscal tightening that we saw in the 2011 debt limit deal are less likely now, we can look at the shifts seen in that period for some sense of how 2023's debacle could play out:
To mitigate the risk of the impact of Europe's sovereign crisis (which was raging at the same time in 2011), Goldman chose to focus on a relatively narrow window (from July 22 to August 10), in which US dynamics appear to have been the primary driver and over which measures of European sovereign risk were relatively stable
Additionally, as the table below shows, Goldman used their existing models to simulate a large growth shock (we look at a 200bp downgrade to 1-year US GDP growth expectations) and see what impact that would have on stocks, bonds, and credit.
The clearest predictions are for large declines in US equities, credit and bond yields and for a sharp rise in the VIX.
Cyclical equities - including banks - would be expected to underperform alongside the Russell 2000 relative to other major US indices.
The exact timing of market fears around the debt ceiling is still uncertain.
Wilson points out the obvious that even if the deadline itself becomes well defined, the point at which the market focuses on the risks is more fluid (and to add to the complexity, there is also still a lingering risk of a short-term extension that pushes the deadline later into the year). The kink in a month (red region) represents anxiety over tax payments data which if lower than expected could bring the so-called X-Date considerably sooner than expected...
Finally, Goldman warns that any hedges may need to be monetized quickly.
Although the prospect that the Treasury could be forced to redirect scheduled government payments would likely trigger a sharp market reaction, it would also quickly increase the pressure for a resolution.
With a lower prospect of sustained fiscal tightening from a deal than in 2011, resolution might quickly reverse much, if not all, of the growth damage.
In 2011, the deal itself and the fiscal drag it implied fueled further worries about the growth outlook.
Nothing motivates politicians like total carnage in capital markets.