The U.S. government's deal to raise the federal debt limit should bring some relief on the outlook for the economy and markets. However, investors should consider risks that may follow even after the debt-ceiling impasse is resolved.
One of the biggest risks is to the credit rating for U.S. government debt. On May 23, Fitch Ratings placed U.S. sovereign debt on negative watch, noting “the brinkmanship over the debt ceiling negotiations” and the failure of the U.S. authorities to meaningfully tackle medium-term fiscal challenges.
Recall that in 2011, S&P downgraded the U.S. rating to AA+ after the resolution of a similarly wrenching debt-ceiling debate. Thus, even if the U.S. averts a default this time, a ratings downgrade could still happen—and the loss of the coveted AAA rating from a second ratings agency is likely to be more consequential.
Another looming risk pertains to the Treasury’s need to replenish cash in the Treasury General Account (TGA), which is the federal government's operating account to handle daily public money transactions. The debt-ceiling standoff has left the TGA uncomfortably low (below $50 billion, compared with a recent balance of more than $500 billion). Replenishing the account could require the Treasury to issue $730 billion in Treasury bills over the next three months and about $1.25 trillion for the rest of the year.
This expected burst of T-Bill issuance could have consequences for liquidity in other markets, depending on who buys the T-bills. Money market funds would normally be the primary buyers but would likely require higher yields, which would add to the challenge of a high cost of funding facing the regional banking system. On the other hand, if other investors were to buy the T-Bills, they would need to do so using funds invested in other assets, which could drain liquidity in the system for those assets. Either way, the risk of heightened market volatility looms large.
Against this backdrop, the relative calm that pervades markets may not be sustainable. Volatility in equity, rates and credit markets appears relatively contained and well below March levels. However, looking back to 2011, markets were also calm before the X-date but subsequently registered sharp moves. In the three weeks after the resolution, the S&P 500 fell by more than 12%, 10-year Treasury yields declined by 70 basis points (meaning prices for those securities went up) and high-yield bond index spreads widened by more than 160 basis points.
In our view, these changes resulted in part from the fiscal contraction embedded in the agreement that resolved the 2011 debt-ceiling impasse. We don’t know yet what the current resolution will entail and would caution against expecting a similar market reaction this time, especially in Treasury yields. Overall, the risks ahead after the debt ceiling issues warrant concern. Investors should maintain a defensive position in their portfolios, with more emphasis on high-grade bonds in developed markets than equities.
