The latest US debt deal, while it may have had markets breathing a sigh of relief, could presage more volatility in bond and USD markets. A perfect storm could be brewing which could create an interesting upside trend in the VIX index (a measure of S&P 500 volatility).
The stimulus of US government spending is usually balanced by the tightening impact of the US Treasury which will issue the same amount of government debt instruments, like bills, notes and bonds. But during the last six months, because of the debt ceiling talks, this stimulus has been happening in isolation. In a similar manner to quantitative easing, it has compressed credit spreads, boosted equities, crushed volatility, and has muted the impact of Fed tightening.
“The biggest concern for many is the interest payments shouldered by the American taxpayer moving forward,” observed Jack Colreavy, a senior corporate finance associate with Barclay Pearce Capital. “Through an exponential rise in absolute debt, interest payments relative to GDP have doubled from 1.2% in 2015 to 2.4% in 2023 with the government paying US$640 billion in net interest. Moreover, with interest rates at generational highs and with no signs of abatement due to inflation, it is projected that interest costs will hit an all-time high of 3.6% of GDP by 2033 or almost US$1.5 trillion.”
To put that into perspective, interest repayments will be the third highest expenditure after social security and medicare; it will be a larger expense than defence spending of $1.1 trillion.
This process has also helped to mask underlying economic weakness caused by higher interest rates. Many companies are waiting to issue more than a trillion dollars in corporate debt in the hopes that rates will drop.
Here comes the debt tsunami
Starting on 8 June the US Treasury is scheduled to issue more than $1 trillion in new debt. This will act as a quantitative tightening process. Fed chairman Jeremy Powell is, at the same time, committed to maintaining higher interest rates to fight inflationary pressures in the US.
The impact will be the inverse of QE: we should see pressure on stocks with higher volatility and widening credit spreads. Companies that are waiting to issue debt may in fact give up, and could proactively default rather than refinance at these unfavourably higher rates.
Looking back at the past, there was a big Congressional debt ceiling deal in 2011. At that point the Treasury issued roughly the same amount of debt. The VIX index went from 25 to 45 and high yields rose 4%. Stocks lost 10-15%.
- Beginners Guide to Indices
- Crude oil futures ramping up fast on Middle East escalation fears
- Nuway Capital’s route into artificial intelligence infrastructure investment
- Central banks are quietly taking profits in the gold market
How to trade the VIX Index
The VIX index is a measure of stock market volatility based on the number of open options contracts on the S&P 500. Frequently referred to as the Fear Gauge, it is a good tracker of fear and uncertainty in the market. It is possible for investors to trade the VIX either using an Exchange Traded Fund (ETF) which follows the index (e.g. iPath Series B S&P 500 VIX Mid-Term Futures) or via a Contract for Difference or spread bet based straight off the index, available from non-US CFD brokers.
In Europe Lyxor has the S&P 500 VIX Futures Enhanced Roll UCITS ETF, while one of the most liquid volatility ETFs in Europe track the Eurpean VSTOXX index (e.g. the EVIX VelocityShares 1x Long VSTOXX Futures ETN). Note that this latter is tracking European stock market volatility.
