Markets brace for debt default as deadline looms

A debt-ceiling crisis is the latest cloud hovering over investors who are already digesting banking turmoil and recession fears.

The 2023 edition of the debt-ceiling debate is likely to weigh on markets over the next several weeks, according to Wall Street analysts.

Treasury Secretary Janet Yellen noted last week the U.S. could default on its debt as soon as June 1. The call forced many analysts to move up their “X-date” — the date the U.S. is expected to default — and has sent the price on one-year credit default swaps, which measure the likelihood of a default, to an all-time high, according to Oxford Economics.

Concerns around that “X-date” coming without a deal being struck are intensifying as Democrats claimed last week that the Republic plan would push the U.S. into a recession. The two sides appeared at a standoff headed into a highly anticipated meeting on Tuesday between President Biden and Speaker of the House Kevin McCarthy, among other top congressional leaders.

“Financial markets have taken previous close shaves on the debt limit in stride, but market participants are seeing greater political intransigence this time around, with both sides digging in their heels,” John Canavan, lead US analyst at Oxford Economics wrote in a note on Monday.

Fear over the impact of a debt default grew last week after the White House noted that a default would cause interest rates to “skyrocket” and could lead to a “economic catastrophe.”

The current crisis comes amid an uncertain macroeconomic backdrop that already includes recession fears, a tightening credit market and the most aggressive interest rate hike cycle in 40 years — all of which, have already impacted markets at various points this year.

Due to the lack of urgency, debt ceiling fears don’t usually weigh on stocks until the projected default day is within two weeks, according to Bank of America.

So while markets may have one more week to wait, the pressure is likely still coming, BofA argued.

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“We expect this [debt limit] resolution will likely go down to the wire, which means risk of… higher rates [and] broad market volatility in late May or early June,” BofA wrote in a note to clients on May 4.

Some are comparing the political conditions to 2011, where a Republican majority squared off with a Democratic White House led by President Barack Obama. The U.S. officially reached the debt limit on May 16, 2011. The S&P 500 hit its peak returns for the year that month before nosediving over the next several months of debt ceiling deliberation.

Stocks have been on a similar trajectory this year, with the S&P 500 up almost 8% since the beginning of 2023. Evercore ISI argues this debt ceiling crisis could play out just as it did in 2011.

“Like 2011, a Debt Ceiling resolution is unlikely until a degree of concern is seen in stocks (Retest of SPX 3,800), as exhibited in U.S. [credit default swaps],” Evercore ISI macro research analyst Julian Emanuel wrote in a note to clients on Sunday.

Due to the debt crisis, and other factors, Evercore and Emmanuel don’t see material upside for the S&P 500 this year.

But there could be opportunities elsewhere. Former Pacific Investment Management CIO Bill Gross told Bloomberg that investors should buy short-dated Treasury bills with the expectation that the debt ceiling crisis gets resolved.

Josh is a reporter for Yahoo Finance.

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