Vijay Kumar Gaba

In this context, the following trends may be pertinent to note, especially for the equity investors.

Negative divergence in OECD debt and yield

The elementary principle of economics is that the price of anything is a function of demand and supply equilibrium. Higher demand pushes the equilibrium to a higher price point and vice versa. However, the bond markets in developed economies have been defying this principle for the past 25yrs. The debt of OECD countries rose sharply post the global financial crisis (GFC) in 2008-09; but the yield on government bonds fell till 2022, creating a negative divergence in bond supply and bond prices.

The situation has shown some signs of reversal in the past one year, but this may not last if the US Federal Reserve decides to begin easing rates sometime in the next 12months, while the latest debt ceiling deal results in a massive rise in bond supplies.

This trend is relevant for equity investors, since this could keep the cost of capital lower, affording much higher price earnings multiples to various businesses.

Deflationary pressures to persist

Post the GFC, the developed economies in particular have struggled with persistent deflationary pressures. Despite unprecedented new money printing and near zero (and negative) rates, major economies faced strong deflationary forces. Consequently, the prices of financial assets and real estate witnessed strong bull markets. The reported debt deal would result in further strengthening of deflationary forces which are structurally aided by the adverse demographic changes and changing consumption patterns.

Indian debt no longer lucrative to USD investors

The spread between US and India benchmark 10yr G-Sec yields (318bps) is presently at its lowest level, at least since the GFC. Given the hedging cost and just 2 notch above junk rating for India G-Sec, presently the Indian bonds may not be very attractive for the USD investors. Though there is not much empirical evidence available to substantiate this, there is a probability of rise in flows to Indian equity, which has been witnessing strong FPI selling for the past couple of years.

The latest episode of political squabble over raising the limits within which the US government could borrow to meet its fiscal deficit, reminded of this inspiring fable. In the past two decades we have seen multiple “debt ceiling crisis” in the US. In the 15 years period from 2001 to 2016, the US Congress raised the debt ceiling 14 times. During President Obama’s tenure of 8 years, the debt ceiling was raised 11 times. Prior to that President Bush’s tenure saw 7 hikes in the debt ceiling. It is also pertinent to note that in the past 100 years, the debt ceiling has only been increased. It has never been reduced, even when the US public debt was reduced.

It is important to clarify that the Gephardt rule, as per which passing of the budget was deemed as an automatic hike in the debt ceiling to meet the approved deficit, was repealed by the Congress in 1995. Since then, appropriation in the budget and means to fund such appropriations are voted separately by the Congress. If the Congress does not vote to hike the debt ceiling in accordance with the appropriation bill, the government will run out of money to meet its interest, salary, social security and other obligations. A default on debt service would inevitably entail a rating downgrade and hike in interest rates that could impact US bond holding of all investors; besides resulting in overall higher interest rate burden on the economy.

Prior to almost every hike in the debt ceiling there had been intense politicking and aggressive posturing by both the parties. The president and treasury secretary contend that not hiking the limit may result in total collapse of the global financial system; while the majority in Congress seeks multiple assurances and concessions before agreeing to the demands.

Going with the tradition, the treasury secretary Janet Yellen has recently stated that “Waiting until the last minute to suspend or increase the debt limit can cause serious harm to business and consumer confidence, raise short-term borrowing costs for taxpayers, and negatively impact the credit rating of the United States”. She further added, “In fact, we have already seen Treasury’s borrowing costs increase substantially for securities maturing in early June.” Also, there has been usual “huge cost to American Public” and “risk of global financial instability” rhetoric being played from the Capitol Hill.

In the past, markets would usually take these warnings seriously and turn jittery. This time however, markets appear relatively much calmer; as if calling the bluff of the politicians. The collective wisdom of the market appears believing that like every previous instance, both the parties would agree to hike the debt ceiling before the 1^st June deadline. Few traders seem to be taking the customary warnings being issued by rating agencies like Moody’s; investment bankers like Jamie Dimon; and Democrat leadership.

The point is whether wolves will actually come this time and eat the complacent traders? Hard to imagine, given the historical context. But would you continue to assign a zero probability to this 8-Sigma event? More on this next week.