Over the weekend, Morgan Stanley reminded its clients that perhaps the biggest threat facing markets over the coming weeks is the “three-headed policy monster” inside Washington: raising the debt ceiling, passing a budget and embarking on tax reform. As MS cross-asset strategist Andrew Sheets noted, "none are easy, but we see the debt ceiling as the most immediate test."
He then cautioned that while the most likely outcome is that, after some tension, the debt ceiling gets raised "we don’t think it will be easy, or smooth, and it may require some form of market pressure to get different sides to fall in line. I’ve spoken to investors who are comforted by FOMC transcripts from 2011 that discussed prioritization of debt payments in order to avoid default. I am not. First, I worry that this reduces the urgency of what remains a serious issue. Second, this prioritization would require delaying payments to programmes like Social Security and Medicare, with real human and economic cost. And third, while the mechanics of this prioritisation may work, it is untested in a live environment."
Perhaps sensing that the market is getting increasingly concerned about the potential standoff over the debt ceiling debate, which could eventually lead to a technical default, moments ago Treasury Secretary Steven Mnuchin, speaking at an event in Louisville, said that "we need to raise the debt limit and it’s my strong preference is that there’s a clean raise of the debt limit."
While Mnuchin conceded that he is "all for spending controls” and Congress has the “absolute right and the absolute obligation” to oversee spending, the Treasury secretary issued another stark warning that "he’ll run out of authority by end-Sept. to stay under the debt ceiling." Said otherwise, Congress will have just days to reach a compromise on the debt ceiling when it returns from recess.
Assuming that Mnuchin is correct, and that the D(ebt)-Day actually falls in September, that would mean that the T-Bill kink noted previously will shift forward, most likely to the last week of September.
Potentially complicating matters is that as Morgan Stanley observed, the fact that "debt prioritization" remains an explicit option laid out by the Fed in 2011, may be just the reason why Congress will take its time, assuming that there is a loophole to a last minute deal as neither side rushes to comrpomise, which in turn could lead to the dreaded outcome, however short it may be.
Mnuchin also added redundantly that "we can’t put the credit of the United States on the line” as reserve currency of world and major economy." This is a continuation of what Morgan Stanley said: "the idea that America’s creditworthiness is beyond reproach is, without exaggeration, the cornerstone of the global fixed income market. We hope that politicians appreciate the seriousness of this issue and put politics aside to resolve it. History is watching."
History may be watching, but most markets so far are not?
Recall that when it comes to discounting any potential complications over the coming debt ceiling showdown, US T-Bills have been well ahead of the broader "Wall of Worry", as shown both above and in the charts below.
Indeed, the dislocation in front-end rates deemed “at risk” given the likely timing of any missed or delayed payment should persist right up until there is a resolution, with the pricing of risk becoming more pronounced the longer there is inaction. But when will remaining asset classes follow and start selling off on fears that an 11th hour solution won't be reached?
Judging by historical examples, "it is not unusual for equity markets to be comparatively sanguine until it is within the month of the deadline", according to Deutsche Bank.
In 2011, the VIX oscillated somewhat in the months ahead (with modest rises at a roughly similar lead to the debt ceiling deadline as the current rise in vol), but the meaningful move higher did not come until about a week prior to the eventual resolution. In 2013 (when the debt ceiling deadline coincided with a government shutdown), the larger pop in equity vol occurred about three weeks before, peaking about a week prior to the resolution. It has not been uncommon to see some degree of equity drawdown about two months ahead of the debt ceiling deadline, with another more muted sell-off arising alongside with the aforementioned rise in volatility, though through this lens the evidence is perhaps somewhat less conclusive.
In other words, while the market has shown remarkable complacency so far and stayed stoically sanguine about the late September debt ceiling fireworks, this may change very soon. Deutsche Bank's conclusion:
September presents itself as a possibly pivotal month during which Congress must pass a new budget and raise the debt ceiling and the Fed may still yet press ahead and announce the start balance sheet normalization. It would seem that if the Fed declines to acknowledge the possibility that more pervasive inflation weakness may warrant a pause, and political gridlock persists, dragging negotiations to the brink, the type of self-reinforcing vol spike and risk-off may not be far off.