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Important Reminder
The information in the following article was accurate at the time of creation but may no longer be reliable due to changes in tax regulations, laws, or other events.
Last week the Republican Party and the White House negotiated a compromised deal to increase the debt-ceiling and cap federal spending. Today, the 31st of May, Congress is voting on the bill. At the time of writing (31.05.23) if passed by majority in the House, the bill would be reviewed by the Senate before it can be signed by the President.
The debt ceiling is the total amount of money the US government can borrow and failing to increase this limit may have catastrophic economic consequences. Effectively, this would mean a US government default (i.e., a failure by the US government to meet its debt obligations) which would be unprecedented.
The issue is important because if left unresolved it would lead to great uncertainty. The United States is one of the largest borrowers in the world and a default would trigger a major crisis across fixed income markets, with a sharp increase in borrowing costs as well as large drawdowns in equity markets due to the increased instability in the financial system. Furthermore, the US currency would depreciate, and all these shocks might lead to a sharp recession both in the US and globally.
In retrospect, the debt ceiling has been renegotiated many times before, so why wouldn’t it be renegotiated this time around? It is also true that, historically, the US has not defaulted on its debt commitments, however investors are becoming increasingly concerned whether a resolution will be agreed on time. The probability of default has sharply increased, as seen by the rise in short term Treasury Bill yields. Although ex-president Donald Trump downplays the severity of such a potential event, the cost of insurance against a possible default as measured by the US Sovereign CDS (credit default swaps) has surged.
In an environment when volatility increases it is common for investors to take some risk off and to start buying Treasuries or Government bonds, especially shorter dated T-Bills. However, the performance of these instruments has experienced swings as prolonged negotiations on the debt ceiling have increased uncertainty and heightened risk. This can be seen in the chart below which shows the yield payable on various US Treasury maturities. We can see from the green line that yields have increased over the past weeks and months.
Source: Factset
Curve remains heavily inverted (a signal that markets believe shorter term bonds to be higher risk than longer ones) with the US 1 month rate at 5.15%, a 2-year yield at 4.42% and a 10-year yield of 3.65% (as of 31 May 23).
Long-term rates have fallen driven by demand for Treasuries as market participants expect slower growth and lower inflation in the long run. As long-term rates are lower than short term rates, investors have been buying shorter maturity bonds, possibly in the expectation that rate cuts are on their way, which would cause these bonds to rise in value. So which way are rates actually going to go? Surveys suggest that most market participants tend to align with the FED. We think it is prudent to look beyond the FED and the yield curve shape and focus on variables like economic growth and inflation when forecasting rates. Recent growth data has been comforting and inflation has started to fall, at least in the US. The UK might be an area where inflation, and particularly food inflation, remains stickier. Energy prices have also fallen, which means that inflation is on a downward track. We continue to monitor the news flow of data and believe that unemployment data and CPI (consumer price inflation) reports due the first half of June will be significant releases. If the employment data is moderate and inflation is benign, the FED might stay on hold. If unemployment rises or GDP declines, we may see some rate cuts but if inflation picks up again (although more unlikely) rates could even go higher. So, a few scenarios remain open which requires staying diversified.
Moving away from rates and bonds, semiconductor stock Nvidia has been reaping the benefits from the latest trend in town – Artificial Intelligence (AI) – and has seen its share price surge and market cap reach close to $1 trillion, joining the ranks of some of the largest US companies. It is astonishing to see such share price performance amid an environment of tight monetary policy and potential recession. AI is seen by many as this new phenomenon that can lead to euphoric booms in equities. Could it even start a brand new ‘AI revolution’? It can undoubtedly improve efficiencies and raise total factor productivity, yet the wider implications of its full spillover effects to the economy and the society are yet to be felt.
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The value of investments and the income from them may go down as well as up and investors may not get back any of the amounts originally invested. Because of this, an investor is not certain to make a profit on an investment and may lose money. Exchange rate changes may cause the value of overseas investments to rise or fall.
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