If the 2011 fight over the US borrowing limit is any indication, stocks could fall during the debt-ceiling crisis. However, investors would still choose long-term Treasurys, according to Sevens Report Research.
Is the stock market in danger?
Tom Essaye, the founder of Sevens Report Research, said that just because the debt ceiling is reached and the Treasury Department is unable to sell further Treasuries does not mean that the US is insolvent or in default.
The Treasury will have to ration its available funds, prioritizing which bills to pay and which to skip, as a result.
“Treasury may pay interest on existing Treasury debt, soldier’s salary, social security, and not pay federal workers’ salaries and federal contractors,” he stated.
The US could reach its borrowing limit in just 3 weeks, thus blocking further sales of Treasury notes by the Treasury Department. That’s a concern because Treasury sales are how the federal government pays for its daily operations.
Sevens Report, which based most of its analysis on the debt limit “drama” of 2011, speculated that investors might be pushed into long-term Treasuries. This is due to the possibility of the US defaulting on its debt.
Treasury Secretary, Janet Yellen, has cautioned that June 1st might be the so-called X-date for the US to hit its debt ceiling. In 2011, as the US was very close to hitting its borrowing limit, the yield on the 10-year Treasury note dropped.
When a large number of investors buy Treasury paper, bond prices increase and interest rates fall. When the 2011 debt ceiling drama really intensified, the 10-year rate was approximately 3.2%. The yield on the 10-year Treasury note fell to 2.7% “by the time the US got to the eve of hitting the ceiling.
When the market finally bottomed out in late October 2011, “the 10-year yield had dropped to 1.80%,” as the report put it. Even if “hitting the debt ceiling doesn’t mean the US automatically defaults on its debt,” as Essaye put it, that means they’ll have to direct cash to essential services and payments and not pay less essential services.
If the Treasury were to restrict payments, it could create a huge headwind for economic growth. Essaye suggested, however, that some investors may be viewing the argument over raising the debt ceiling “almost like a pothole in the road.“
How will different assets behave?
Gold “did prove a useful hedge against debt ceiling uncertainty and likely will again this time,” he added. But, he cautioned that it’s a trade as a hedge, not a long-term hold to avoid hitting the debt ceiling.
Stocks perform poorly after debt ceiling “dramas,” even if the matter is resolved at the last minute. According to Essaye, the debt ceiling drama really intensified in the summer of 2011, when the S&P 500 dropped. More than 20% of its value was wiped out between May and October, with the index falling another 15% after an extension of the debt ceiling.
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There are concerns about the possibility of a repeat of the debt-ceiling crisis of 2011 in the high-yield credit market as a result of the current level of uncertainty around the US borrowing limit. 2011’s macroeconomic background was reportedly difficult due to the shaky banking system in Europe and the sovereign-debt crisis in the US.
Will stock market investors get scared as the debt ceiling debate heats up? We’ll see soon. Stocks in the US moved sideways this week and the unemployment rate in the US remained at 3.4% in April, which is still a record low.
This time is different for sure. However, interest rates are still high and inflation is not in the target zone, suggesting there might still be some trouble ahead.