Over the weekend, Morgan Stanley reminded its clients that the biggest threat facing markets over the coming weeks is the “three-headed policy monster” inside Washington: raising the debt ceiling, passing a budget and embarking on tax reform. As MS cross-asset strategist Andrew Sheets noted, “none are easy, but we see the debt ceiling as the most immediate test.”
He then cautioned that while the most likely outcome is that, after some tension, the debt ceiling gets raised “we don’t think it will be easy, or smooth, and it may require some form of market pressure to get different sides to fall in line. I’ve spoken to investors who are comforted by FOMC transcripts from 2011 that discussed prioritization of debt payments in order to avoid default. I am not. First, I worry that this reduces the urgency of what remains a serious issue. Second, this prioritization would require delaying payments to programmes like Social Security and Medicare, with real human and economic cost. And third, while the mechanics of this prioritisation may work, it is untested in a live environment.”
As reported earlier, the market’s concerns about a potential debt ceiling crisis, so far mostly contained, have once again started to bubble to the surface, with the Oct. 5 T-Bill rate rising to the highest level since August 1st, suggesting that bond traders see rising odds of a “worst case outcome” and partially answering our question from Monday whether “Markets Are Sleepwalking Into A Debt Ceiling Crisis: Mnuchin Issues Another Warning.“
Additionally, the yield spread between the Sept 28 and Oct 5 Bills is now the widest on record:
The blowout has come after the latest warning by Treasury Secretary Steven Mnuchin, who on Monday said that “we need to raise the debt limit and it’s my strong preference is that there’s a clean raise of the debt limit.”
However, as of this morning, it’s not just the debt ceiling that traders have to worry about, because as discussed overnight, a new potential problem emerged last night when Trump told a Phoenix rally that he is commited to securing funds for a border wall, even if it results in a government shutdown.
While last night’s rally audience loved the threat, Democrats promptly blasted it: on Wednesday, Chuck Schumer ripped Trump for threatening to shutdown the government: “If the President pursues this path, against the wishes of both Republicans and Democrats, as well as the majority of the American people, he will be heading towards a government shutdown which nobody will like and which won’t accomplish anything,” Schumer said on Wednesday. Including funding for a physical wall is considered a non-starter for Democrats, whose votes will be needed to get a government funding bill through the Senate.
We doubt a warning from the Senate Minority Leader, or any other Democrat or Republican for that matter, will have much of an impact on Trump’s decision-making if he has indeed set his mind on procuring border wall funding. Which is also why in a note from Compass Point released this morning, strategists Isaac Boltansky and Lukas Davaz warn that not only is the risk of a government shutdown bigger than the debt limit, but that Trump’s commitment to securing funds for a border wall, together with Trump’s “injurious relationship” with GOP leaders – best demonstrated by last night’s NYT bombshell article laying out the open war between Trump and Senate Majority Leader Mitch McConnell – “dramatically raises the spectre of a shutdown in October.” Here are the highlights of their note, courtesy of Bloomberg:
- The prospect of a govt shutdown “still poses a potentially serious downside risk for investors,” even as “our firm belief that the debt ceiling will be lifted removes a profound political risk from the landscape”
- Trump’s commitment to securing funds for a border wall “dramatically raises the spectre of a shutdown in October” and his “injurious relationship” with Congressional Republican leadership “further complicates the underlying calculus”
Compass Point adds that four factors increase the potential for an equity market sell-off as government shutdown risks intensify:
- Further delays confirmations, which would affect Trump’s deregulatory agenda;
- Delivers a “psychological blow” to markets, serving as a “concrete symbol” of Washington’s inability to govern;
- Delays legislative progress on tax reform;
- Alters Fed’s policy normalization trajectory
In summary, while Compass Point says that lawmakers will promptly raise the debt ceiling in mid-September, or less than a month from now – something which Morgan Stanley and others find hard to believe – a government shutdown in October suddenly all too likely.
Then, shortly after the note was released, rating agency Fitch also chimed in and warned that if the U.S. debt limit is not raised in a timely manner, it would review the U.S. sovereign rating, with potentially negative implications. In other words, Fitch is warning that a repeat of August 2011 – when S&P infamously downgraded the US to AA+ after the failure to raise the debt ceiling resulted in a brief technica default0 is now on the table. The silver lining: Fitch said that a government shutdown following a debt ceiling increase, such as the one envisioned by Compass Point, would not direct affect on U.S. AAA rating.
Finally, for those who are still on the fence about the likelihood of a shutdown and are otherwise unhedged, one month ago Bank of America put together a “costless” spread collar trade, should volatility surge in the coming weeks as a debt ceiling/government funding deal emerges as unlikely. Here again is how to make money should the US government shut down in just over a month.
Trade idea: VIX Oct 12/14/19 call spread collar for zero-cost upfront
We are comfortable selling VIX puts to leverage a likely floor in volatility, particularly ahead of the debt ceiling, and using the premium collected to the cheapen the cost of portfolio protection. For example, investors may consider selling the VIX Oct 12 put vs. the 14/19 call spread, indicatively zero-cost upfront with a net delta of +54 (Oct fut ref 13.35).
The trade leverages the facts that (i) VIX 3M ATMf implied volatility, while low, is not necessarily cheap compared to the level of the VIX 3M future (Chart 14), and (ii) VIX 3M call skew is currently very steep, in the 92nd percentile since Sep-09 (Chart 15).
More critically, while VIX call spread collars have been challenged by recent sub-11 VIX settlement values, they can be successful, low-cost hedges when there are defined macro catalysts on the calendar to provide support to volatility, as seen from the US election and more recently the first round of the French election.
Lastly, we are comfortable capping upside via the call spread as the VIX 1M and 2M futures have not closed above 20 since Brexit over one year ago.