US debt ceiling analysis Why haven t the markets started to sell off aggressively Some have already

I have been asked many times over the past week why equity markets have not aggressively sold off as investors digest the US debt ceiling and potential default scenario? The truth is, some asset classes have reacted and there are perfectly understandable reasons why others haven’t, yet.

Let’s first cover the asset classes which have reacted.

Short-term treasuries

Of all US treasuries, the only dated paper to see yields rise is very short-term such as the one month. Longer term yields such as one-year and even 10-year have not reacted with any real impression. Why? Longer term yields reactions are weighted within the context of Fed taper expectations, where it now looks increasingly unlikely that the Fed will look to taper before Janet Yellen arrives as the head of the Fed (assuming her ratification goes through as expected). Longer term yields have fallen ever since the Fed no taper decision as a result.

Short-term yields which are more sensitive to short-term risks have not moved dramatically either. However, extremely short-term yields such as one month bills have. One month bill yields have rallied from 0.0025% to 0.3220% in the space of just four weeks. That’s a huge move. The chart below shows you how one month bills have seen their yields rise in the last few weeks vs longer term five-year and 10-year. This move echoes a sentiment that traders are acknowledging the short-term risks posed by the deadlock on Capitol Hill but this acknowledgement is recognised only in the short term and for good reason. This is not the first time the markets have been left waiting for US politicians to reach an agreement that has gone down to the wire. If the deadlock continues until Wednesday, we will start to see a more aggressive investor reaction that will likely broaden out to longer term dated paper.

Credit Default Swaps (CDS)

CDS markets have also seen a reaction. The cost of insurance against a default has risen significantly as investors resort to CDS during times of uncertainty. Take a look at the chart below of both US five-year and 10-year CDS from Markit. The costs have more than doubled in the last month and a new upsurge has begun after a sell off last week on hopes for a short-term agreement.

Onto Stocks

Stocks have sold off, they have just not sold off as aggressively as many headlines would suggest. The Dow, S&P and FTSE have all fallen around 5%-6% in the space of three weeks as the deadline has loomed.

So why haven’t stocks sold off more aggressively? For me there are three reasons:

1: Are investors still in the market?

Many investors banked terrific gains thanks to the QE induced rally from the first part of the year, with all major indices still in double digit growth for year to date (YTD).

The only investors still in this market are the desperate (those that missed out on the previous gains) or the greedy (those that want more). Why would traders put their huge gains from the start of the year at risk with just over two months to go until the year end?

2: Short sellers are proving too sensitive

When the market is net short, it does not take much to rally as short sellers have to buy back when they come to square their short positions. When the trader mentality is short, any upside surprise is artificially inflated therefore. That’s what we saw last week with equities rallying on the seeming progressive bi-partisan talks for a temporary lifting of the US debt ceiling. This is preventing any prolonged equity weakness, for now.

3: The Fed QE policy is an effective stop loss

The Fed’s QE policy and lack of tapering is keeping investors interested and looking for long opportunities. The Fed had of course been expected to taper $85bn of monthly purchases to at least $75bn in September. This was not forthcoming and so as such, the market is happy to rest on the belief that the Fed will remain proactive in case market risks start to escalate.

Summary

And so as you can see, certain asset classes are already reacting to the developing situation on Capitol Hill. These are perhaps not as visible as a 4%-5% decline in stock indices but they are there for all to see. Investors have already started to mitigate against the risks. The closer we edge to Thursday’s debt ceiling deadline the more sensitive stocks will become and the more we will start to see the risks visible in short term yields and CDS seep into other asset classes such as stocks.

This is not the first time that a deadlock in Washington has gone right down to the wire. A US default would have significant consequences and the stakes are high. The House and the Senate both know this. It would not surprise me if a short-term agreement (one-year) is reached in time for ratification on Thursday. However, the situation is becoming increasingly volatile and if the last few years have shown us anything, it is to expect the unexpected with US politics.