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By almost any measure, the US debt ceiling has been a costly failure. Uncertainty around raising the debt ceiling has led to repeated bouts of market volatility, higher government borrowing costs, and potentially years of slower growth, according to academic studies and US Government Accountability Office reports. The record-setting US national debt now exceeds the annual GDP, will soon exceed the record post World War II levels of debt-to-GDP, and is on pace to reach 135% of GDP by 2040, according to the non-partisan Congressional Budget Office.
We believe that further down the track, the debt ceiling limit in the US is set to be a bigger issue than the market is currently priced for. There is a lot of complacency around this, but this can and probably will change quickly at some point during the summer. The so called ‘X-date’ which is the point at which the US Treasury runs out of cash, is a moving target that is dependent on the combination of tax receipts, spending and the effective management of cash resources. It is likely to be sometime towards the end of July but may even extend longer into August.
When we analyse the politics in the US, we see more polarisation and discord than ever before. Kevin McCarthy, the leader of the Republican caucus in the House, has a razor thin majority and there is a group of hard-line Republicans who will not be shy to cause substantial volatility to get their way. The relationship between McCarthy, the Democrat controlled Senate and the White House is non-existent. The different protagonists in this drama are miles apart and the views are more intrenched and polarised than ever before. We think it unlikely a deal will be reached ahead of the X-date. The more difficult question is how to play this.
While it is too early to be positioning for the event, it is swinging into focus. The most likely outcome is going to be a period of ‘risk-off’ driven by fears of either a default type event, or swift and severe reduction in government spending that causes the market to anticipate a more severe economic downturn. This will be a primary focus for us in the coming months and we anticipate a good opportunity to generate returns from this thematic. If you look at the SVB crisis, it is interesting to note that Jerome Powell, Chair of the Federal Reserve, was talking up the growth and inflation trajectory at the beginning of March and wanted to force a hawkish step change in the pricing of the Fed’s rate hiking path. It is very apparent he was very unsuspecting of the chaos that would erupt in the US regional banking sector.
We take this as a warning sign that stress can come out of nowhere, associated with sectors of the economy and or financial system that no one suspects. This will continue to be the case through the course of 2023. And we think that the market is somewhat complacent in this regard. Consequently, we think that we are going to be faced with further volatility, in rates and in equities and FX this year. But for us, that opens up opportunities in the macro sense.
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