Comment from ING on the US debt negotiations.
US Senate leaders reached a last-minute deal on reopening the government and suspending the debt ceiling. As the debt limit is only extended by a few months, the relief will only be temporary. It is nevertheless a reason for us to increase our risk-on stance by upgrading equities, real estate and credits.
Debt ceiling deal is a temporary relief
One day before the 'infamous' deadline of October 17, the US Senate and House of Representatives finally managed to pass a deal to get the government back to work and suspend the debt limit, albeit for a short time. The deal opens government again until January 15 and suspends the debt ceiling until February 7, 2014. It also requires negotiations to reduce the budget deficit to be completed by December 13. The automatic, across-the-board spending cuts (also known as sequestration) that began in March, were not lifted. The next round of cuts is due to take effect in January when the temporary spending measures end. Their removal is expected to be a key part of the budget negotiations.
Given the short window for successful budget negotiations the current deal has delivered, this chapter in American politics is not over yet. We may yet return to similar brinksmanship later this year or early next year.
Fed tapering probably postponed until 2014
The whole debt ceiling debate cannot be seen being separate from monetary policy. In fact, the members of the federal open market committee (FOMC) are probably thanking their lucky stars for not having reduced the pace of asset purchases in September. Although the Fed stated it wants to start tapering in 2013 when it explained its decision not to taper yet in September, we believe that December tapering is off the table now that the debt ceiling is only extended for a short period.
Therefore we now expect this to happen in the first quarter of 2014, possibly already in January but it may come as late as March. Given the fact that the whole tapering discussion had such a big impact on Treasury yields (not because this 'should' happen but because the market confuses tapering with tightening) one would expect any further rise in Treasury yields in the next few months to be very much a function of what is happening in the real economy.
Fed policy under new chairwoman won't change materially
The monetary part of the equation may play a rather neutral role given the fact that the future Fed Funds curve has flattened substantially already since the latest FOMC. What's more, even when the Fed starts tapering we believe that there is a distinct possibility that the Fed, under its new Chairwoman Janet Yellen, will have figured out by then how to convince the market that its strategic game plan is still intact. We do not expect a material break with the Bernanke era and Yellen is expected to refine the forward guidance instrument further. The promise not to raise the Fed Funds rate under certain conditions that would normally give rise to a tightening of policy will most likely see some innovations under the Yellen regime.
Markets discount a more dovish Fed outlook
Markets have been pricing in a more dovish outlook for the Fed Funds rate since September. This is reflected in the price of the December 2015 Fed Funds future contract (a higher price implies a lower yield). Last Thursday bond markets also judged an early tapering of asset purchases less likely, as the Treasury yield dropped to 2.60% from 2.75% a day earlier.
Markets remained remarkably calm
Despite the fact that the debt ceiling deadline that was formulated by the US Treasury department was getting very near, markets remained remarkably calm throughout the whole political drama that unfolded in Washington. Equity markets traded higher in October until the deal was reached, while the VIX index, one of the most well-known proxies for investor anxiety, shortly bounced up early October, but never reached the stress levels seen in the past few years. Given the dramatic implications of a US default and the fragile state of US politics, it is surprising that markets have behaved so resiliently. Call it complacency, a sign of underlying strength or simply crisis fatigue, it is remarkable from any perspective that not more risk aversion has been seen in investor behaviour over the past weeks.
Over the past years and in particular during the euro crisis and fiscal cliff talks in the US investors have on several occasions been confronted with deadlines and ultimatums. Every time a solution was found, not always an elegant one but good enough to keep the ball rolling, 'kicking the can further down the road'.
Economic and corporate fundamentals give support
This time, economic and corporate fundamentals continue to improve, while tapering seems to be postponed until 2014. The nomination of Yellen as the next Fed chair gives us every reason to believe in a 'lower for longer' monetary policy. European data surprise to the upside and also the Japanese recovery gains further traction. Emerging markets got some more room to breathe from the delay in tapering.
We have increased our risk-on positioning
The improvement in economic fundamentals and the ongoing support from monetary policy are also the main reasons why we held on to our growth oriented, moderate risk-on stance in the past weeks. Now that the deal is reached in the US, we have increased our risk positions somewhat. We upgraded our neutral positions in real estate equities and credits from neutral to overweight, while we moved equities from a small to a medium overweight position. Meanwhile we have moved government bonds from neutral back to a small underweight position.