May 2, 2023
The probability for a technical US debt default remains below 10%, but the likelihood for a credit rating downgrade may be fairly high. The debt ceiling has been raised 78 times since 1960 with two recent events that came down to the wire resulting in US sovereign credit rating downgrades. The first happened in August 2011 with a downgrade on August 4 resulting in a -4.8% single day decline in the SPX. The downside actually started about three days before the downgrade resulting in a ~13% total decline before a post-deal recovery on August 9. Ten-year Treasury yields fell from 2.74% on August 1 to 2.11% on August 10 before reaching a low of 1.72% in late September. A ‘flight to quality’ trade also resulted in relative US dollar strength of ~5% and a ~15% rally in gold. Implied volatility spiked during that episode with the VIX rising from ~20 to a peak of 48 on August 8. Elevated volatility is a headwind for equity rallies and it takes time to return to ‘normal’ levels. In 2011, it took more than two months for the VIX to fall back below 25. The other credit downgrade occurred during the debt ceiling debate in October 2013. Markets followed a similar, but far more muted pattern with the downgrade causing a -1.3% single day decline in the SPX. The magnitude of the market reaction was affected by an unknown number of variables, but the direction was the same. In both episodes, the market reaction started about 2 weeks before the actual ex-date. Last night, the Treasury Secretary said it could be as soon as June 1, but extraordinary measures could push the ex-date further into the month. We’ll get clarity on the ex-date in the weeks ahead, but a down to the wire agreement would likely result in downside for the SPX, upside in bond prices, US dollar strength, upside for gold and increased volatility.
The fundamental case to remain bearish seems easy with higher funding rates and elevated equity multiples skewing risk/reward to the downside. The technical case to remain bearish is also easy with the narrow leadership, thin market breadth and the SPX at the upper end of range resistance. The hard part will be recognizing the bullish inflection point. The bullish inflection point during past tightening cycles occurred weeks before a Fed pivot. Unfortunately, those prior Fed pivots all followed a period of acute economic pain and more significant downside in asset values. The problem with being ‘tactically bearish’ is that everyone else is already there and sidelined cash is at record levels.