We tried last night to have our monthly Open Office Hour zoom meeting. Technical difficulties caused problems and I decided to write to you instead. We were looking to cover the following topics: CPI, Debt Ceiling, YTD relative performance of stocks, bonds, real estate, Mental/Financial Health, our Core Program, Crypto and AI. Talking we can cover a lot of ground. Writing consumes more time and attention and that’s a rare commodity as of late so here’s a brief discussion about the most important topic we were going to cover the – The Debt Ceiling Debate.
A debt ceiling debacle, which is a failure by the government to raise or suspend the debt limit, can have significant negative effects on financial markets and the economy as a whole. Here are some potential market outlooks in the event of a debt ceiling debacle:
Stock market: The stock market may experience significant volatility and declines as investors become increasingly uncertain about the government's ability to pay its debts and the potential consequences for the economy. This uncertainty can lead to a sell-off of stocks, particularly those that are seen as more risky. We are looking at alternatives to hedge this debate. Tech and aggressive growth stocks have been leading the markets higher this year because of their direct correlation to interest rates and inflation. If we don’t solve the debt ceiling issue the stock market could fall and inflation rise as the dollar comes under pressure. The Federal reserve response under a US default is not easy to predict. There is a short term event and many institutional level investors have been buying hedges while siumultaneously investing more aggressively because the Fed appears done raising interest rates. Volatility is coming down by some measure (the VIX) but hedging this event is elevated. One way to hedge is to buy a protective put on the highest beta (volatile) part of the market.
Bond market: The bond market may also be negatively affected by a debt ceiling debacle, as investors demand higher yields to compensate for the increased risk of default. This can lead to higher interest rates and borrowing costs, which can in turn slow down economic growth. The debt rating of the US is the core/base rate underlying the entire bond market. A default could cause a rise in this key rate and then vibrate out through the whole spectrum of bonds. The mechanism for this is declining prices. The federal reserve could act to lower rates to try and combat this but they may also be faced with a declining dollar. The current inflation was supply and demand driven. Inflation like we had in the 70’s and 80’s was currency driven. This kind of currency valuation event is harder to control and therefore may place the Fed in a catch 22 situation.
Foreign exchange market: The US dollar may also come under pressure in the event of a debt ceiling debacle, as investors lose confidence in the currency and seek safer alternatives. This can lead to a depreciation of the dollar and higher inflation. It can also cause foreign investments to outperform domestic. Here in the US we have had a very long run of being the preferred investment. This could change with a single event like this one. It also could change as countries like China and Russia look to create a competing currency regime. The Euro was thought to offer such an alternative as well, so we have been here before.
Overall, a debt ceiling debacle can have significant negative effects on financial markets and the economy, leading to increased volatility, higher interest rates, slower growth, and a weaker US dollar. It is important for policymakers to address the debt limit issue in a timely and responsible manner to avoid these potential consequences. We are discussing how to hedge this and may buy a protective put on the NASDAQ (high beta stocks) DOW (global corporations) Dollar or Volatility. If our government waits to long this hedge could be a great strategy to get us through the short term turbulence. Call if you have questions or concerns. It feels like on the other side of this issue is a more normal environment.