[Outlook-in-Five] US Debt Limit – Some ceilings need to be broken

Over recent months, investors would have seen various news headlines about the US Treasury reaching its debt limit, and the attendant concerns for the economy and markets. As this debt limit has been reached in January, the US Treasury has now begun the usage of extraordinary measures, which most expect to only last till sometime in the second half of this year before a default occurs. This is certainly a development that warrants much attention. Bank of Singapore’s investment strategist, Joseph Ng, shares more about the follow-on impact to investors, should a default by the US Treasury occur. __________________________ [Transcript - excerpt] Many of our listeners out there would have seen various news headlines about the US Treasury reaching its debt limit, and the attendant concerns for the economy and markets. This is certainly a development that warrants much attention. The debt limit is the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments. As this debt limit has been reached in January, the US Treasury has now begun the usage of extraordinary measures, which most expect to only last till sometime in the second half of this year before a default occurs. Should a default by the US Treasury occur, investors should then expect downgrades by rating agencies. The follow-on impact could be as such: First, borrowing costs for the Treasury (and by extension the taxpayer) will increase. Second, the perceived creditworthiness of large financial institutions could be impacted, as some of these are viewed by investors to be implicitly backstopped by the federal government. Third, foreign investors could also look to trim holdings of Treasuries. Taken to the extreme, this could also pressure the dollar, leading to inflationary pressures. Our base case is that Congress will reach a last-minute agreement with some form of concessions made to the House Republicans in order to raise the debt ceiling. A last-minute deal will likely be the most politically expedient option for both parties. However, the obvious risk is that negotiations turn out to be more protracted than expected and go past the deadline, thereby risking a debt default. This would then leave the economy and markets in unchartered territory. There are other theoretical alternatives that the Treasury can take, but these are all fraught with legal and practical challenges. In short, there are unlikely to be any feasible solutions, except for Congress to arrive at a compromise to raise the debt ceiling. Over the last 5 notable debt limit episodes historically, we note that there has been some amount of variability in terms of market behaviour, with much depending on the intensity of debt limit disagreement and the overall macroeconomic backdrop. The impact of debt limit episodes on equities and volatility is generally muted outside of 2011. Across all 5 episodes, the S&P 500’s median peak-to-trough drawdown was at 4%, while VIX increased by only 7 points. While 2011 was an outlier in terms of downdraft and volatility in equities, we do not rule out the possibility that markets today could be in a similar situation as it was then. In Fixed Income, Treasury bills maturing around the debt limit deadline typically tend to underperform. In our view, this could reflect investors’ concerns around timely redemption of such securities that are soon to mature. We also observe that the US Sovereign CDS spreads also tend to widen as debt deadlines loom. As we approach the debt limit deadline, we believe that companies that derive a significant portion of revenue from the US government could see significant volatility. These include defense contractors, selected healthcare companies, and companies that render professional services to the US government.