Why share and bond markets are at loggerheads

It’s been helped by a better-than-expected corporate earnings season and by a conviction within the markets that an interest rate cycle that has led to the Fed hiking the federal funds rate by 5 percentage points since March last year is, if not over, then at worst one final 25 basis point increase away from the end.

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Even the more rate-sensitive technology stocks have held up well, with the tech-laden Nasdaq index up nearly 5 per cent over the past three weeks.

It could be that equity investors, who do tend to be optimistic, believe that despite all the sabre rattling and the polarised and antagonistic state of US politics, there will be a resolution of the debt ceiling crisis at the eleventh hour.

There are mixed messages coming out of the opposing camps about the progress, or lack of it, being made in discussions between the Democrats and Republicans in Congress.

The White House, where Joe Biden will meet congressional leaders again this week, is making encouraging noises. The Republican House leader, Kevin McCarthy, is saying the meetings haven’t been productive.

The US came closest to a default on its debts – so close actually that Standard & Poor’s lowered its AAA credit rating – in 2011, when a deal was struck on July 31, two days before Treasury would have exhausted its cash holdings.

Between the fortnight leading up to the agreement and the fortnight after, US equities fell heavily, with the S&P 500 down about 17 per cent. International stock markets were also hit, tumbling about15 per cent before the markets settled.

Interestingly, bond yields fell sharply both in the lead-up and aftermath of that brush with disaster, which perhaps reinforces the view that, regardless of events, US Treasuries remain the world’s safe haven for investors. Gold, another refuge in stormy times, also fared well, rising more than 20 per cent.

That was what happened when the US flirted with a default but didn’t actually default. Whether the same themes would carry through a real default is uncertain.

Equity markets would, however, almost certainly be the most vulnerable of financial markets. The White House’s Council of Economic Advisers recently ran a simulation which had the US sharemarket plunging 45 per cent.

Recession risk

Whether investors would, as they did in 2011, see Treasuries as a safe haven if there was a major question mark over the status of their bonds and whether the interest and principal would be paid and whether the securities could be traded is an interesting question. Most analyses have seen an initial spike in yields in the event of a default.

One certainty is that the US would be cast into recession. Indeed, that might still be the case even if there is only a “technical” default.

There is a thesis that the Biden administration could keep paying the interest and make principal repayments on its debt while freezing other spending, such as the public service, Medicare and defence. The US has had government shutdowns before, where salaries and social welfare payments have been withheld.

Even that more moderate outcome would probably lead to recession, albeit not as deep or prolonged than one caused by missed payments on the government’s debts, which would cause financial chaos and probably spark recessions globally.

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A US recession might be on the cards even if the debt ceiling discussions produce a compromise that averts a default.

But there are signs that the US inflation rate – as inflation rates elsewhere – is subsiding. Last week, the headline rate fell below 5 per cent for the first time in two years, although “core” inflation still remains at levels that the Fed is uncomfortable with. There might well be at least one more US rate rise to come and that might be sufficient to tip the world’s largest economy into recession.

If common sense prevails in the debt ceiling negotiations (a big “if,” given the make-up of the House, particularly the Republican side of it), then the sharemarket investors might be on a winning bet, looking through a mild recession to the falling interest rates and looser monetary policy that would support the rising valuation for shares that occurred in 2011.

If they are misreading the future of either the debt discussions and/or the Fed’s future course, then the shocks in equity markets in the US and elsewhere will probably be magnified, and very unpleasant.

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