Here’s why a debt-ceiling resolution may still impact investors like you
Morgan Stanley Research06/05/23
Summary: The market may breathe a collective sigh of relief following a debt-ceiling resolution, but here’s why investors may want to consider staying alert.
- A debt-ceiling resolution offers investors some relief, but risks could still linger.
- A potential US credit-rating downgrade could be problematic for some portfolios holding Treasuries.
- Replenishing the Treasury General Account would boost T-Bill issuance and have an impact on banking liquidity and the availability of cash.
The US government’s deal to raise the federal debt limit may bring some relief on the outlook for the economy and markets. However, investors should consider potential risks that may follow now that the impasse is over.
- One of the biggest risks is to the credit rating for US government debt, which could possibly add to market volatility. On May 24, Fitch Ratings placed US sovereign debt on negative watch, noting “the brinkmanship over the debt ceiling negotiations” and the failure of the US authorities to meaningfully tackle medium-term fiscal challenges.1
Recall that in 2011, S&P downgraded the US rating to AA+ after the resolution of a similarly wrenching debt-ceiling debate.2 Thus, even if the US averts a default this time, a ratings downgrade could still happen–and the loss of the coveted AAA rating from a second ratings agency is likely to be more consequential.
- Another looming risk pertains to the Treasury’s need to replenish cash, which could drain liquidity and make borrowing more expensive. The debt-ceiling standoff has left the Treasury General Account (TGA) uncomfortably low (below $50 billion, compared with a recent balance of more than $500 billion).3 Replenishing the account could require the Treasury to issue $730 billion in Treasury bills over the next three months and about $1.25 trillion for the rest of the year.
This expected burst of T-Bill issuance could have consequences for liquidity in other markets too, depending on who buys the T-bills. Money market funds would normally be the primary buyers but would likely require higher yields, which would add to the challenge of a high cost of funding facing the regional banking system. If other investors were to buy the T-Bills, they would need to do so using funds invested in other assets, which could drain liquidity in the system for those assets. Either way, the risk of heightened market volatility remains.
Against this backdrop, the relative calm that is apparent in markets may not be sustainable. Looking back to 2011, markets were also calm before the X-date but subsequently registered sharp moves. In the three weeks after the resolution, the S&P 500 fell by more than 12%, 10-year Treasury yields declined by 70 basis points (meaning prices for those securities went up), and high-yield bond index spreads widened by more than 160 basis points.4
While Morgan Stanley strategists would caution against expecting a similar market reaction this time, especially in Treasury yields, overall, the risks ahead may warrant concern. Investors may consider:
- Maintaining a defensive position in their portfolios;
- Taking on more emphasis on high-grade bonds in developed markets than equities.
- Source: https://www.fitchratings.com/research/sovereigns/fitch-places-united-states-aaa-on-rating-watch-negative-24-05-2023
- Source: https://money.cnn.com/2011/08/05/news/economy/downgrade_rumors/index.html
- Source: https://www.axios.com/2023/05/23/debt-ceiling-us-treasury-bank-balance-chart
- Morgan Stanley Wealth Management as of May 31, 2023