The U.S. has never defaulted on its debt, but the looming deadline to raise the debt ceiling, combined with political brinkmanship in Congress, has increased the odds. Heading into 2022, the odds of a U.S. default (as measured by credit default swap spreads, i.e., insurance against losses on Treasurys) has increased from 0.2%-0.3% in 2022, to approximately 1% in 2023.[1] While the default likelihood remains low, it’s the highest level we’ve seen since the 2011 debt ceiling impasse.
Synopsis:
- It’s more likely than not, that a debt ceiling compromise will be made
- The last time the U.S. experienced debt ceiling jitters in 2011, U.S. debt was downgraded, however interest rates initially declined due to “risk off” market sentiment
- In 2011, U.S. Treasury bond interest rates eventually settled higher, increasing the cost of interest payments to the U.S. government, creating economic weakness
- If a default were to occur, in the near-term equity and bond markets would likely capitulate to the downside and a drop in the value of the dollar would lead international stocks and bonds to outperform on a relative basis (all else being equal)
- Longer term opportunities include moving shorter duration assets (especially cash equivalents and short-term high-quality bonds) to longer duration high quality bonds and adding to equities at attractive price levels
While the risk of default is low and our likely scenario is a compromise (perhaps at the 11th hour), risks remain which could lead to a repricing of bonds beyond Treasurys. Because U.S. Treasurys are deemed to be “risk free”, the mere potential of a default could increase the perceived risk of Treasury bonds, leading to a ratings downgrade. Any downgrade in the quality of U.S. debt would ripple through bond markets, driving higher relative yields on other bonds that are priced relative to Treasurys. This is what occurred in 2011 during the debt ceiling debacle, even though no default occurred.[2]
Interestingly enough, U.S. Treasury yields actually declined initially in 2011 following the downgrade of U.S. debt instruments (indicative of a price increase on the underlying bonds). This initial interest rate decline was due to a “risk off” trading environment which drove money from stocks into safe-haven high quality bonds. Eventually interest rates on Treasurys settled higher which increased the interest costs for the U.S. government, creating economic weakness.
If our government finds a path to compromise and the U.S. does not default, the markets will likely return their attention to economic and inflation data in assessing recession risks. If, however, the U.S. does default (which would likely be for a very short period of time), stock and bond markets will react adversely in the near term. A sharp equity sell-off (especially in interest sensitive stocks), bond re-pricing and a drop in the value of the dollar relative to other currencies could be expected.
Keeping a long-term view, however, higher yields offer a more attractive entry point for bonds, especially in longer duration assets. The benefit of longer duration high quality bonds (like U.S. Treasurys in particular), is their historically negative correlation (or relationship) with stocks during periods of equity bear markets, where long term Treasurys rise in value while stocks decline in value. This negative correlation would be enhanced by rate reductions, which the Federal Reserve would have to revisit in earnest. Higher yields create an opportunity to move from short-term cash and short-term high-quality bonds to longer maturities to lock in yields for longer. In addition, a drop in the dollar would make international equities and bonds priced in foreign currencies rise in value (all else being equal) relative to U.S. dollar denominated assets, a good reason for portfolios to be diversified globally. Lower stock prices could also offer a good entry point to add to equities.
Uncertainty and the speed of market movements make it impossible to time these types of events perfectly. However, focusing on the probable long-term outcome allows investors to make prudent decisions to take advantage of short-term market turbulence.
[1] https://www.reuters.com/markets/us/debt-ceiling-jitters-lift-us-credit-default-swaps-highest-level-since-2011-2023-04-20/
[2] https://www.rbadvisors.com/insights/is-the-safe-haven-still-safe/