Barclays warns of loan limit deadlock as ‘tail risk’ market phenomenon

In a recent note to clients, strategists including Manish S. Deshpande wrote that a debt limit deadlock could be a tail risk event for equity markets, and added that the possibility of a US default is no longer “at any point in the past decade”. More than” .”

Strategists said the previous debt limit debate was resolved through bipartisan agreements, but this time deep political divisions in Congress mean Democrats may have to tackle the debt ceiling using budget reconciliation.

“With a 50-50 Senate and three-man majority in the House, this leaves almost no room for error,” Barclays said. “This increases the risk of the process breaking down and Congress missing the October 18 debt limit deadline.”

The forecast doesn’t hold up to the firms’ baseline, and they expect Congress to eventually raise the debt limit and avert the breach. Nevertheless, he advised clients to buy the VIX call spread to hedge the event.

Given that debt-limit negotiations coincide with a cacophony of macro risks – the Federal Reserve’s pledge to cut monetary stimulus and China’s real estate crisis – it’s hard to tell why concerns over the phenomenon have led to recent gains. How much has equity jumped? The stock market has historically brushed off debt limit concerns, although fears of a default have led to a jump in yields of short-term Treasury bills.

Some strategists turned to the derivatives market for guidance and found no sign of worry.

For example, take the futures curve of the CBO Volatility Index. The gauge, widely known as the VIX, saw its futures showing a similar slope as they did a month earlier through November — a segment that covers the October 18 time frame. When Treasury Secretary Janet Yellen said her department would run out of cash. This means that options traders do not view the deadlock as a material risk.

Barclays studied the volatility curve of the S&P 500 and came to a similar conclusion.

“There is only a small bump in the SPX volatility curve around the October 18 time frame and the front end of the curve has flattened compared to the previous month,” the strategists said. “Options markets do not appear to be particularly concerned about increasing debt limits.”