Barclays Sees Debt Ceiling Impasse as ‘Tail Risk’ Market Event
(Bloomberg) -- While options markets seem unbothered by the ongoing debt ceiling drama, Barclays Plc is warning investors to be prepared.
In a recent note to clients, strategists including Maneesh S. Deshpande wrote that a debt ceiling impasse could be a tail risk event for equity markets, and said that the chance of a U.S default is now “greater than at any point over the past decade.”
Previous debt limit debates were resolved through bipartisan agreements, but this time the deep political divide in Congress means Democrats may have to tackle the debt ceiling using budget reconciliation, the strategists said.
“With a 50-50 Senate and a three-member majority in the House, this leaves almost no margin for error,” said Barclays. “This raises the risks of the process breaking down and Congress missing the October 18 debt ceiling deadline.”
The forecast isn’t in the firms’ baseline case, and they expect Congress will ultimately raise the debt ceiling and avert a breach. Nevertheless, they recommended clients buy VIX call spreads to hedge the event.
Given the debt-ceiling negotiation coincides with a cacophony of macro risks -- the Federal Reserve’s pledge to cut monetary stimulus and China’s real estate woes -- it’s hard to tell how much of the recent equity swoon is due to worries over this event. The stock market has historically brushed off debt ceiling concerns, though fear of a default has appeared to spur a jump in yields of short-term Treasury bills.
Some strategists turned to the derivatives market for guidance and found no signs of worry.
Take the futures curve of the Cboe Volatility Index, for instance. The gauge, widely known as the VIX, saw its futures showing a similar slope as they did a month ago through November -- a stretch that covers the Oct. 18 deadline when Treasury Secretary Janet Yellen said her department will run out of cash. That means options traders have not viewed the impasse as a material risk.
Barclays studied the S&P 500’s volatility curve and reached a similar conclusion.
“There is only a small bump in the SPX volatility curve around the October 18 deadline and the front end of the curve has flattened over last month,” the strategists said. “Option markets do not appear to be particularly worried about the looming debt ceiling.”
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