Concerns around a US political showdown to raise the debt ceiling and a potential technical default by the US are likely to intensify over the next few weeks. Our base case is for an eventual agreement between the two political parties to raise the debt ceiling and avoid a default, but the journey is likely to be marked by elevated volatility. Heading into this period, investors could consider adding exposure to medium to long-term government bonds, safe-haven currencies, such as the Swiss Franc and the Japanese Yen, and gold to protect against bouts of volatility.
What is all the fuss about the US debt ceiling?
Concerns about fractious political negotiations between the Republicans and the Democrats to raise the US debt ceiling and thus avoid a US technical default have come into market focus over the past two weeks. The elevated concerns have been driven by two factors:
- Weaker-than-expected tax collection in the April tax season meant that initial estimates of the so- called “X-date” – when the US Treasury can no longer pay its bills – has been brought forward from the earlier estimates of August 2023.
- US Treasury Secretary Yellen warned last week that the X-date could be reached as early as 1 June, further heightening the concerns.
The risk of a technical US default has risen recently, based on the Credit Default Swap (CDS) market where investors can buy protection against a potential default. One-year US CDS spreads are now higher than 2011 and 2013 debt ceiling deadlocks. However, once we factor in CDS market technicalities, the market-implied probability of a US default is still lower than the peak seen during the previous US debt ceiling battles in 2011 and 2013. For instance, one-year US CDS spreads currently imply approximately 4% probability of default, compared with over 6% probability indicated in July 2011.
Fig 1: US debt ceiling has been raised 78 times since 1960. The US hit its current debt ceiling on 19 Jan
US Treasury total public debt outstanding and US debt limit
Source: Bloomberg, Standard Chartered
What is the likely path from here on?
Our base case remains that the US is likely to avoid a technical default, though it is quite likely that the negotiations will go down to the wire before an agreement is reached. However, it is important for investors to understand the potential scenarios that could play out during this process:
- Debt ceiling is raised before the X-date: In an ideal scenario, Democrats and Republicans can reach an agreement on raising the debt limit in a timely manner, ahead of an X-date. However, given the increase in political polarisation in the US over the past decade, we would assign a low probability to this outcome. As an aside, we would also note the calculation of the X-date itself is an estimate involving several assumptions. The exact X-date can be difficult to predict precisely.
- No agreement till X-date, but US avoids default: No agreement to raise debt ceiling by the X-date does not automatically imply a US default. Looking at the contingency plans formed in 2011, the US Treasury could prioritise debt and coupon payments and cut back or delay spending on healthcare, social security and payment to vendors, among other things, to avoid a default until an agreement is eventually reached. This would dent US growth and increase the risk of a US recession, especially if a final agreement involves long-term spending cuts.
- US defaults on government debt: This is the least likely, but the most damaging outcome, in our opinion. However, the US Treasury does have a few tools at its disposal, such as rolling over debt by one day to delay this
Fig 2: Classic safe-haven assets such as US government bonds, Swiss Franc and gold rose in the lead-up to the 2011 US debt ceiling showdown
Performance from 31 May 2011 to 2 August 2011
Source: Bloomberg, Standard Chartered
How can investors position their allocations?
From an investor perspective, the last two scenarios mentioned above are likely to be negative for risk assets. Any agreement to raise the US debt ceiling is also likely to come with some spending cuts, which would act as a drag on the economy and be negative for US equities. However, investors have a few options to add a defensive tilt to their portfolios:
- High-quality bonds: Looking at the past debt ceiling showdowns, medium-to-long-term US government bond yields declined (prices rose). Increased risk-off sentiment should drive demand for safe-haven assets such as government bonds, though a key assumption here is that the US ultimately manages to avoid a technical default.
- Safe-haven currencies: Increased safe-haven flows, deteriorating US growth prospects and decline in US government bond yields should lead to a decline in the USD index (DXY). Safe-haven currencies such as the Japanese Yen and Swiss Franc are likely to be the key beneficiaries. We see a high likelihood of a stronger Euro as well, given the Euro area’s stronger near-term growth prospects and potential for the European Central Bank to continue raising rates, while the Fed pauses.
- Gold: Although gold prices have rallied significantly over the past few months, a spike in debt default concerns could cause gold to test USD 2,200 /oz. We would look to add exposure to gold on dips.
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