Are mainstream investors ready for disaster? With a U.S. government debt default looming in what Treasury Secretary Janet Yellen described as an “unthinkable” move with “dire consequences,” we may be on the verge of finding out.
For professional hedge fund managers who only make money during catastrophes like financial crises and pandemics, it’s easy to prepare for the worst: Just keep buying options and other instruments at cheap prices to hedge against sudden price drops. Then, when the nightmare strikes, count your billions, put on your best suit and go on Bloomberg TV and say you don’t like other people’s pain.
More typical fund managers who can’t afford to make money only once in ten years face a trickier task.
On the face of it, they are bracing themselves for the remote possibility that the markets that underpin the value of every asset on earth are about to backfire. Prices for U.S. credit-default swaps — a derivative that insures against non-payment — have risen significantly, although little has changed hands compared to the size of the market. That means some investors, likely hedge funds, especially those that thrive on disaster, have placed low-cost, high-reward bets on a market crash. But even this market itself doesn’t look panicked.
Meanwhile, one need only glance at the U.S. stock market to see that there is nothing amiss. The benchmark U.S. stock index, the S&P 500 , has been flat since late March. Given the continued slowdown in inflation, you can justify that it should be higher, so the debt ceiling cliff edge could hold it back. perhaps.
Still, this isn’t a market that looks like it’s only about three weeks away from a government debt default. Still, it’s a serious possibility; unless Congress raises or somehow redefines the U.S. debt ceiling, the federal government will find itself unable to pay a range of payments, including debt holders, as soon as early June .
It’s hard to overstate how problematic this is for the market. If U.S. Treasuries fail, stocks, bonds and everything in between will wobble in unpredictable and violent ways. The desperate dash for cash in March 2020 and the UK gilt crisis in 2022 are just two reminders of how quickly sudden market shocks can turn ugly.
The current relative calm has several sources. One is the general belief among analysts and investors that cooler heads will prevail. Congress will strike a deal or find some sort of fabrication or gimmick to avoid the horror show, as it did the last time this issue really erupted in 2011, as it has done 78 times since 1960. Fund managers feel like they’ve seen this movie before, and it always ends.
This time it is dangerous to assume that politicians will find a compromise. As the political analyst Tina Fordham has pointed out, the disposition to solve problems calmly and intelligently is not a valuable asset in congressmen these days. She sees a roughly 20% chance of a U.S. debt default in the coming weeks. “The 20 percent happens all the time,” she said on CNBC this week.
Another reason this hasn’t really hurt stocks yet is that, just as it’s impossible to have a little pregnancy, “it’s hard to price in a little default” at Rabobank, said rates analysts Richard McGuire and Lyn Graham-Taylor. “Thus, CDS and T-bills reflect increased hedging demand, while equities . . . seem somewhat isolated as the brinkmanship game ends.”
Analysts at Rabobank agree: “Our base case is that a default can be avoided.” Even so, they point to another big danger, which is that, for the politicians involved, chaos itself is an important part of the process .
“It is in the interest of both parties to show a willingness to support (by default) for as long as possible, as this maximizes the likelihood of concessions if the other side blinks first,” they said. “(That) does raise the clear risk that the market’s apparently broader optimism on this front will be tested in the coming weeks.”
That’s the view of Sushil Wadhwani, chief investment officer at PGIM Wadhwani. “In an increasingly polarized environment, politicians need to see major market volatility to strike a deal,” he said in a note this week.
Investors are conditioned to believe that if there is some sort of downturn in the market, stocks will recover quickly. As Wadhwani pointed out, it doesn’t help. “There is concern that the market is complacent and that investors could be suddenly hit,” he said. “Investors don’t want to see a fiscal tightening surprise at a time when the risk of a U.S. recession has already risen and the chances of a hard landing are increasing.”
If you think it’s going to be all right, then you’re probably in the same camp as Donald Trump, who thinks “it could be really bad, it could be nothing, maybe it’s a bad week, or a bad day of the week” , who knew? It might help with concentration.
katie.martin@ft.com