On October 16 an agreement was reached by the US Senate and Congress that should allow for the funding of the government until January 15, 2014, and the extension of the country’s borrowing authority through February 7, 2014. The US fiscal crisis is, at least temporarily, resolved.
The political gridlock has inevitably had an impact, particularly with respect to the performance of and prospects for credit markets. While the shutdown persisted, yields on short term T-bills maturing towards the end of October, which would have been the most at risk in the event of a default, spiked higher. There was also an increase in the sovereign one-year Credit Default Swap (CDS) contract for the US, which reflects a rise in the costs to insure against a default. During this month US credit indices underperformed their European counterparts in relative terms – the US CDX IG rose more than the European iTRaxx Main (as shown in the chart), reflecting a perception of higher credit risk associated with US credit rather than with European credit.
There were outflows from US money market funds that buy US Treasuries or US government-backed debt over the past two weeks. Also, US corporate bond issuance and trading volumes decreased during the shutdown. Issuers postponed funding decisions and the attractiveness of US bonds decreased relative to European bonds.
However, considering what was at stake, there was no major shift in credit markets. The 10-year yield on the benchmark US Treasury note peaked at around 2.75 per cent in the past month, hardly a level of borrowing costs of a nation about to default. Overall, corporate credit spreads did not widen considerably. As shown above, credit derivative indices did not rise to crisis levels.
Ironically, by seemingly delaying the withdrawal of the extraordinary monetary stimulus, the US fiscal crisis is being viewed as relatively positive for debt markets.
In part, this could be related to investors’ belief throughout the political impasse that ultimately an agreement would have been struck before the deadline. However, this relative “indifference” likely also reflects the fact that the primary interest of global debt markets is the expected slowdown by the Fed of its bond-buying programmes, rather than political turmoil in Washington. It is the shifts in expectations on the timing of tapering that continue to drive fixed income markets.
In this respect, it is therefore relevant to highlight the probable impact of the shutdown on the Fed’s plans for ending quantitative easing. Original expectations for a decrease of bond purchases in September were already being postponed before the crisis – mainly due to the uncertain progress in US employment figures. Recent events have further increased this perception of a delay amongst investors.
In theory the Fed’s monetary policy is detached from the political bickering on fiscal policy. However, the reality is that the disruption to economic growth caused by the shutdown (with for example S&P ratings agency projecting that 0.6 per cent of annualised fourth quarter GDP growth was lost) is now expected to push back tapering.
Additionally, there are also practical considerations.
The partial closure of the federal government delayed the publication of important economic reports and prevented some data collection.
This may make it more difficult for the Fed to gauge the true state of the economy in the coming weeks and months, and more likely it would prefer to err on the side of caution.
Most forecasts are now expecting tapering to commence in the first quarter of next year, with Bloomberg surveys showing that even a starting date before March is unlikely.
Ironically, by seemingly delaying the withdrawal of the extraordinary monetary stimulus, the US fiscal crisis is being viewed as relatively positive for debt markets.
This could be interpreted as a reflection of the markets’ “addiction” to high levels of liquidity. Even beyond this consideration, the backdrop for credit in Europe remains supportive, with a scenario of decreased event risk, weak economic growth, low interest rates and relatively low default rates.
This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Karl Falzon is a credit analyst at Curmi and Partners Ltd.