The deal with no debt-ceiling deal: impact on markets
In the US, stakes are high and the outcome is uncertain regarding debt-ceiling negotiations. In order to prevent the US from defaulting on its debts, Democrats and Republicans need to reach an agreement about raising the debt ceiling before X date. The impact on financial markets depends on when the parties are able to shake hands.
X date is defined as the date where the US government can no longer pay its bills. Early May, ABN AMRO economists indicated that it could potentially be as soon as early June, but more likely late in July. The uncertainty regarding the X date is related to the fact that taxes and spendings are always difficult to monitor on a day-to-day basis. For example, if the US government is able to reach a deal mid-June (a key tax-payment deadline), US Treasury will likely have enough in reserve to keep it going until late July. During the weekend, Treasury Secretary Janet Yellen claimed, however, that the “odds of reaching 15 June while being able to pay all of our bills is quite low”.
What are the scenarios?
We consider that there are four scenarios: the first is that a deal will be reached in the coming days, without having any impact on the economic outlook. The three other scenarios are detailed by the White House itself: brinkmanship, short default and protracted default.
The brinkmanship scenario will likely be the one where a deal is reached around X date. In that case, the White House estimates a limited impact on growth and unemployment.
The short-default scenario is the one where the US defaults on a few of its obligations (such as US Treasuries as well as loans and bills), as Congress is unable to raise or suspend the debt ceiling during a few days. The consequences of this scenario could be more significant on the economic outlook as emphasised by the White House. It will mean a 0.6%-contraction of real GDP.
The last scenario is the protracted one, where the US defaults during a longer period, leading to a severe recession with a huge increase in unemployment.
Potential impact on financial markets
There is no historical precedent for the US government passing X date and breaching its debt ceiling. There are, however, examples where negotiations between the two parties were tense: in 1996, 2011 and 2013. In 1996, the impact on financial markets was unsignificant. In 2013, there was some volatility during a few days without significant disruption. The situation in 2011 was totally different, however, with a very significant risk-off phase for risky assets. But there were also other factors playing at that time pressing on European government debts.
Figure 1 shows possible scenarios of the impact on financial markets, all else being equal. Three main ideas should be taken into account:
- The closer we get to the X date or the default, the higher the impact will be on financial markets;
- The impact of such a development will be negative for risky assets, such as credits, equities and commodities;
- The impact will be positive for government debt (with an exception for US short-term government debt that is already suffering from uncertainties).
Source: ABN AMRO Investment Centre
What is the most likely outcome?
Our economists stated recently that there are two most likely outcomes: either a last-minute deal in late May or early June, or a suspension of the debt ceiling to allow more time for negotiations. The former seems the more likely, as negotiations last week started to reach a deal. After positive talks, negotiations stalled late Friday and would restart on Monday with a new meeting between Speaker of the House of Representatives Kevin McCarthy and President Joe Biden.
In this scenario, the impact should be modestly positive for equities and neutral for other risky asset classes, as they do not exclude other outcomes so far. However, it could be (slightly) negative for government bonds – in particular for US Treasuries – as the US will issue new loans to increase its general account. Once the deal is reached, investors will refocus on the economic outlook and in particular on the monetary policy of the Fed, inflation and growth.
What investors should do?
Historically, political events can generate a short-term spike of volatility in financial markets, which are typically temporary (such as Brexit, the commercial war between China and the US et cetera) as long as the economic outlook is not hampered. As a consequence, we recommend investors to remain calm during the possible unrest surrounding this political event.
Olivier Raingeard de la Blétière - Global Head of Equity Strategy