The United States is once again approaching the so-called “X-date”, i.e. the day when the government runs out of money.
One could almost call the recurring wrangling over the debt ceiling a ritual; in game theory it is known as the “Game of Chicken”, with two cars driving towards each other. Both parties hope that the other will yield or swerve first, but, if they miscalculate, disaster ensues.
So the stakes are high and financial markets are preparing for potential turbulence. Treasury Secretary Janet Yellen warned that the X-date could come as early as 1 June, earlier than most analysts had expected.
President Biden met with congressional leaders on Tuesday 9 May to discuss the urgency of preventing a default and starting to negotiate a budget. However, the meeting ended without any tangible results.
The risk of a default is still considered a “tail risk”, i.e. very unlikely in principle, but market fears are increasing as the deadline approaches. We expect the political debate on the debt ceiling to be even more contentious this time around due to the highly polarised political climate in the United States.
It remains unclear whether any party will concede and how far politicians are willing to stretch it out, knowing that the X-date estimate is likely to be a conservative one, is a major issue.
The most likely outcome, in our view, is a short-term suspension or increase in the debt ceiling if Republicans decide that an agreement before 1 June is unlikely. Exceeding the X-date, in which the US Treasury prioritises interest and principal payments on government bonds but defers other payments – such as federal employees’ salaries – is seen as almost impossible. The even more unlikely scenario of an actual sovereign default would lead to violent market reactions and almost certainly trigger a deep recession.
So far, financial markets have reflected the risks of the debt ceiling only to a limited extent. In the past, markets have started to get seriously concerned about a default due to the debt ceiling two to four weeks before the expected X-date. However, there are exceptions that already indicate some nervousness: The yield on 1-month T-bills rose to 5.76% after an auction on 4 May, an increase of 240 basis points in just two weeks. The 1-year CDS premium also rose sharply to 166 basis points, suggesting that investors fear a low, but rising, probability of default.
This brinkmanship could lead to significant volatility in equity markets, which would also have a negative impact on other risk assets. The US dollar could weaken further, which should lead to more investment in other safe havens, such as government bonds and currencies of the eurozone or Japan. Paradoxically, however, a flight to safe US government bonds would also be on the cards, analogous to 2011, when the US faced a similar crisis. The gold price is also likely to rise further in the event of a severe debt or budget crisis.
In the 2011 budget crisis, financial markets experienced significant volatility and deterioration in the financial environment around the X-date (a compromise was only reached shortly before). The US credit rating was downgraded one notch by S&P from a perfect triple A to AA+, and the volatility index (VIX) soared, while the S&P 500 plummeted. The gold price also rallied sharply.
Investors should closely monitor further developments and market reactions in the coming weeks. They should also consider positioning their portfolios accordingly and hedge against possible market fluctuations.
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