One might think that all of the battling in Congress over passing a continuing resolution to fund the government and raising the debt ceiling would increase volatility in financial markets.
After all, the political brinksmanship has already resulted in a partial shutdown of the U.S. government, and now investors are “thinking the unthinkable” when it comes to the debt ceiling, which needs to be raised in a few weeks or the U.S. will be forced into technical default on its debt.
BofA Merrill Lynch interest rate strategist Ruslan Bikbov argues that the dysfunction in Washington is actually having the effect of making markets less volatile, for two reasons: (1) it increases the odds that the Federal Reserve will refrain from tapering back its quantitative easing program anytime soon; and (2) the blackout on government-released economic data during the shutdown is removing some of the biggest catalysts for volatility from the market.
In a note to clients, Bikbov writes:
Although a short-term government shutdown is unlikely to have any measurable economic consequences, a prolonged shutdown should have a negative effect on GDP. Our economics team estimates that a two-week shutdown can erase as much as 0.5% of GDP growth. As a result, continuing brinkmanship increases the odds of a delayed Fed tapering and therefore should be negative for volatility, especially in the upper-left part of the vol surface. What’s more, with BLS and BEA closed we are set to have a smaller inflow of data in the coming days. In particular, September payroll report is most likely to be delayed. We therefore expect realised volatility to be low in the near term and recommend selling gamma going into next week.
If Congress actually fails to raise the debt ceiling, however, Bikbov says it’s a different story — but not before then:
Treasury default should bring higher vol
The debt ceiling impasse is a greater risk to the vol market, given some chance of a missed payment by the US Treasury. We expect a severe risk-aversion shock in a scenario where a missed payment occurs accompanied by a dramatic increase in market volatility given unprecedented nature of such an event and its disruptive effect on the functioning of financial market.
But expect low vol before the drop-dead date
At the same time, we do not expect a significant rise in volatilities before the drop- dead date. At this point the market is used to last-minute deals from Washington, while far-reaching consequences of the Treasury default are likely to convince most investors a default will not occur. In fact, even during 2011 debt ceiling impasse episode volatilities did not richen going into the drop-dead date of August 2, even though the agreement was reached only on August 1 (Chart 11). Although volatilities eventually increased later in August, this was triggered by S&P downgrade of the US sovereign rating and escalation of the debt crisis in peripheral Europe rather than the debt ceiling impasse itself.
In a separate note, BofA chief investment strategist Michael Hartnett offers three reasons why D.C. has been unable to spark volatility in stocks this year:
- First, the economy. We think investors do not believe the big picture “high liquidity, low growth” backdrop will be disturbed (and that backdrop has been very positive for asset prices). With “fiscal fatigue” high, investors appear unlikely to raise their already-high cash levels due to political tension unless and until a government shut-down/debt ceiling crisis triggers significant cuts in consensus GDP and profit forecasts, e.g., taking 2014 US GDP growth down from 2.7% toward 2%.
- Second, the Fed. Investors know that “debt default” would likely cause a large volatility shock (as in 2011). But we believe investors also expect any rise in volatility to be quickly countered by a risk-positive Fed/Treasury policy response. Fed asset price reflation has completely diluted fiscal policy, in our view. And, shifts in government finances typically follow rather than lead asset price reflation (the improvement in the US government financial deficit from 9.3% of GDP in Q2’2009 and 8.5% in Q1’2011 to 4.0% this year has lagged the outperformance of stocks).
- Third, positioning. We believe investors now want to be structurally “long” stocks and “short” bonds. Stocks have outperformed bonds over the past 3, 5 and 10- year spans. And yet in the past 6 years investors have redeemed $US900 billion from long-only equity funds and bought $US1.2 trillion of bond funds. That positioning now appears to be reversing (and judging by inflows currently pouring into bullish levered ETF strategies the “fast money” seems keen to front-run this Great Rotation). We think this dynamic creates a “sellers’ strike” in equities, and a “buyers’ strike” in bonds.
The chart below shows how volatility spiked after the “drop-dead date” in August 2011.