Are mainstream investors ready for disaster? With the clock ticking close to a US government debt default described by Treasury Secretary Janet Yellen as an “unthinkable” move with “terrible consequences,” we may be about to find out.
For specialist speculative fund managers who only make money in the event of calamities like financial crises and pandemics, preparing for the worst is easy enough: just keep picking up options and other cheap instruments that provide a hedge against sudden falls in price. So when the nightmare scenario hits, count your billions and slap on your best suit to go on Bloomberg TV and say you take no pleasure in everyone else’s pain.
More typical fund managers who can’t afford to make money just once a decade have a more complicated task.
At first blush, they’re prepared for the small chance that the market that underpins every asset value on earth is about to backfire. The prices of US credit default swaps – derivatives that provide a kind of insurance against debt non-payment – have risen sharply, albeit only with small trading volumes relative to the vast size of the market. This means that some investors, most likely hedge funds and especially those that thrive on disasters, have been placing low-cost, high-return bets on a market crash. But even this market doesn’t appear to be panicked, as such.
Meanwhile, a look at the US stock market wouldn’t suggest anything is wrong. The reference point US stocks the S&P 500 hasn’t gone anywhere since the end of March. You can argue that it should be higher given the continued slowdown in inflation, so maybe the edge of the debt ceiling cliff is holding it back. Perhaps.
However, this is not a market that looks like it could be only about three weeks away from a government debt default. It’s a serious possibility, though; Unless Congress raises or somehow dramatically redefines the US debt limit, the federal government will find itself unable to make a series of payments even to its own debt holders, potentially as early as June.
It’s hard to overstate how much of a problem this would be for the markets. If Treasuries fail, stocks and bonds and everything in between will unravel in violent ways that are hard to predict. The desperate run for liquidity in March 2020 and the UK gilt crisis of 2022 are just two reminders of how sudden market shocks can quickly turn into nasty surprises.
The relative calm now comes from several sources. One is that analysts and investors widely believe that coolheads will prevail. Congress will make a deal or find some sort of trick or gimmick to avoid a horror show, just like it did the last time this issue really flared up in 2011 and just like it has done 78 times since 1960. The managers of bottoms feel like they’ve seen this movie before and it always ends well.
This time it is dangerous to assume that the politicians will find a compromise. As political analyst Tina Fordham points out, a calm and sensible problem-solving tendency isn’t exactly a valuable asset to members of Congress these days. She thinks there is a roughly 20% chance of US debt default in the coming weeks. “Events with 20% probability always happen,” she told CNBC this week.
The other reason this still isn’t really hurting stocks is that, just like you can’t be a little pregnant, “it’s hard to discount a little default,” say rate analysts Richard McGuire and Lyn Graham. Taylor at Rabobank. “Thus, CDS and short-term Treasury bills reflect the increased demand for hedging while equities . . . they appear somewhat isolated while playing the game of calculated risk.
Rabobank analysts are with the crowd on this: “Our base case is that a default will be avoided.” Even so, they point to the other big danger, which is that for the politicians involved, chaos itself is an important part of the process.
“It is in both parties’ interest to be willing to accept [a default] for as long as possible, as this maximizes the likelihood of getting concessions if the other party blinks first,” they said.[That] raises a clear risk that the market’s apparent greater optimism on this front will be tested in the coming weeks.”
This is a view shared by Sushil Wadhwani, chief investment officer of PGIM Wadhwani. In a note this week, you said that “in an increasingly polarized environment, policymakers will need to see significant market turmoil to reach an agreement.”
Investors are conditioned to believe that if there is any kind of market downturn, stocks will quickly rally to the upside. As Wadhwani pointed out, this is pointless. “There is concern that the market is complacent and that investors may experience a sudden shock,” she said. “Investors wouldn’t want to see unexpected fiscal tightening at a time when recession risks in the US are already rising and the possibility of a hard landing is rising.”
If you’re dragging along assuming everything will work out fine, maybe you’re on the same side as Donald Trump, who thinks “this could be really bad, it could be maybe nothing, maybe it’s a bad week or a bad day, who knows? That can help focus the mind.
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