G10 FX Weekly: Four Trades for a Debt Ceiling Impasse
- By Richard Jones
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- 5 min read
Summary
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- Democrats and Republicans have been unable to reach a deal after extensive debt-ceiling and budget negotiations.
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Summary
- Democrats and Republicans have been unable to reach a deal after extensive debt-ceiling and budget negotiations.
- The US Treasury has warned it will run out of cash to meet its obligations as early as 1 June, which is now broadly viewed as the so-called ‘X-date.’
- Likely, the negotiations will run down to the wire, with potential acute market dislocation if the deadline is missed.
Market Implications
- An equity market selloff is almost guaranteed unless there is a timely agreement.
- In this risk-off environment, we expect both the Swiss franc (CHF) and Japanese yen (JPY) to be the best-performing G10 currencies. We prefer long CHF and JPY vs all other majors, including the US dollar (USD).
- In the rates space, expect US treasuries (USTs) and German government bonds to outperform.
- Although a traditional haven, the US dollar (USD) will perform less effectively than the CHF and JPY.
Introduction
Negotiations between Democrats and Republicans have so far produced no agreement on the debt ceiling or US federal budget. Market concerns are mounting that the US will run out of cash to meet its obligations, after the US Treasury warned that this could happen as early as 1 June.
My colleague Dominique Dwor-Frecaut wrote last week that contingency planning by the Fed and the Treasury, including payment prioritization, could limit the market consequences of passing the early June ‘X-date.’
Nonetheless, as Dominique acknowledges, an equity market selloff may be required to end the impasse between negotiators in Washington. And although the standoff will probably be resolved before any serious lasting damage to the economy or markets, investors will be looking at trades to offset the negative impact of negotiations exceeding the X-date.
In the FX and rates space, we like a handful of trades should negotiations remain bogged down:
- Short USD/CHF
- Short USD/JPY
- Long USTs
- Long German government bonds
Current State of Play
US equity markets fell into the red on Friday after Republicans walked out of negotiations. Although talks resumed later and into Saturday, both sides were still distant.
On Sunday, before a scheduled call between President Joe Biden and House Speaker Kevin McCarthy, Bloomberg reported that ‘…both sides have engaged in mutual recriminations, with each side accusing the other of negotiating in bad faith.’
After the call, which McCarthy described as ‘productive,’ negotiators for both sides met Sunday, with the President and Speaker scheduled to meet on Monday.
As we explored in our Week Ahead video, the party’s Freedom Caucus (a group of a few dozen conservative Republicans in the lower house) could impede the talks. They are not enthusiastic supporters of McCarthy and called on Friday for the Speaker to suspend his negotiation and focus on passing the ‘Limit, Save, Grow Act’ through the Senate.
This Republican-backed legislation would raise the debt ceiling into next year and impose sharp spending cuts on many initiatives which are priorities for Biden. It is unlikely that the Senate will pass the legislation.
Overall, it suggest McCarthy’s control of the party is tenuous. Both sides are engaging in brinksmanship. And with the clock ticking, the probability of outsized market volatility is growing.
Our Favourite FX and Rates Haven Trades
We now examine our favoured FX and rates trades. For each, we consider the price action immediately following the breakdown in talks on Friday and extrapolate to see what would happen if negotiations faltered in the run up to the X-date.
This is a decidedly imperfect way to look at this volatile situation, and we do not want to overplay it. However, we think it offers worthwhile insight into the potential market reaction.
Short USD/CHF
The Swiss franc is the ultimate FX haven. As we wrote on 4 May, in times of economic, political and market turmoil, the CHF rallies materially and outperforms its G10 peers. For the second half of 2023, we are already bullish the CHF, regardless of the current negotiations.
Price action from last Friday (19 May), when the news of Republicans walking from the negotiations hit the wires, is instructive.
USD/CHF fell ~0.5% within 15 minutes of the news and, while the USD retraced some of this loss, it still finished the day lower by ~0.6%.
This shows how the market reacts to bad news on the negotiations from Washington. Therefore, we can expect markets to react this way to further deadlocks in the negotiations. As such, we like a short USD/CHF position.
Short USD/JPY
Although less sought than the CHF during flights-to-quality in currency markets (see our piece on 11 May for a look at CHF/JPY over the past 15-18 months), the yen is also an FX haven.
Like the CHF, we already think that the JPY will perform well in the second half of 2023, regardless of the debt ceiling debacle.
Price action in USD/JPY last Friday was like that in USD/CHF.
As with USD/CHF, USD/JPY also fell, by 0.7%, within the 15 minutes after the news of the Republican walkout hit the wires. The pair ended the day lower by ~0.5%.
This indicates how the market reacts to setbacks in the negotiations. Consequently, we also like a short USD/JPY position as a hedge to any market volatility resulting from the talks.
Long US Treasuries
USTs have long been the favoured fixed-income haven on any flight-to-safety. The US bond market is deep and liquid and seen as very safe.
With the probability of a recession already high according to the Macro Hive and Fed models, we have expected USTs to perform well in the second half of 2023. A protracted debt ceiling impasse will accelerate a rally.
Price action in USTs on Friday was also quite telling.
In the ~15 minutes after news of the Republican walkout hit the wires, the 2-year UST yield fell by 12bp, closing 8bp lower than the session high.
It is another indicator, like USD/CHF and USD/JPY, of how the markets will react to any further bad news from Washington. We like a long UST position in the current environment.
There is one caveat. In the unlikely event that the deadlock continues for several weeks beyond the X-date, faith in USTs could be undermined, especially if US sovereign debt is downgraded by the ratings agencies.
We do not think it will come to this. And in the near term, USTs will remain a strong hedge against the brinkmanship in Washington.
Long German Government Bonds
German government bonds share similar qualities to USTs in terms of market depth, liquidity and perceived safety. For these reasons, we like them to hedge against drama in Washington.
Like USTs, with the high likelihood of a recession, we are already favourably predisposed to German bonds. And, also like USTs, protracted debt ceiling negotiations will accelerate a rally in German government bonds.
The German 2-year climbed 0.1% percentage points higher in the same 15-minute period, similar to the 2-year UST.
As with the other havens discussed above, this indicates how German debt will react to unfavourable news flow from the negotiations. Long German government bonds is therefore one of our favoured positions.
All Havens Are Not Created Equal
In the FX space, the USD has long been favoured as a haven. This time may be slightly different, though, and we again look to price action from Friday for a guide on how the dollar will react if the talks become even more sour.
In the now-familiar 15-minute period, the Deutsche Bank USD Trade Weighted Index fell ~0.4%, closing the day near the session low. This points to a strong likelihood that the USD will underperform in the event of further delays to a deal.
This does not mean that the USD’s status as the world’s reserve currency is imminently threatened. But it does point to the dollar not being the favoured G10 haven currency in this instance.
After all, this is a ‘Made-in-America’ problem (or, more precisely, a ‘Made-in-Washington’ problem). As such, the CHF and JPY are favoured over the USD now for investors seeking safety in the FX space.
Conclusion
Negotiations between Democrats and Republicans in Washington have been acrimonious and time-consuming. On current evidence, there is little reason to believe that these dynamics will improve before the US Treasury-defined X-date on 1 June.
Investors are therefore keen to seek shelter from broader market volatility in FX and interest rate havens.
We identify long CHF and JPY as the preferred exposures in the FX markets, with both currencies set to perform their G10 peers in the event of negotiations continuing to be bogged down. The USD, a traditional FX haven, will underperform the CHF and JPY.
In the rates space, we think that long exposure to USTs and German government bonds will serve as the best hedge if a resolution to the current impasse remains elusive.