I’ve been pounding the table about the growing risk of a credit event for months and we might finally have our catalyst. Last night’s U.S. government credit rating downgrade by Fitch was something that was lurking deep in the shadows for a little while, but now could be the shock to the system that flips current market sentiment. The path for a very bearish outcome here is pretty clear to make. In 2011, Treasury yields plunged (long-term Treasuries gained around 30% in just over two months). The S&P 500 fell more than 15% in about a month and high yield spreads blew out by 350 basis points over the subsequent 3 months. The VIX jumped from the high teens to 45. The catalysts are roughly the same - a fight in Congress over spending where the debt ceiling is held hostage followed by a rating change. It’s not unreasonable to think that the market reaction could be similar.
So far, the market reaction has been pretty muted. In fact, long-term Treasury yields are down on Wednesday and, while tech and high beta stocks are getting hit hardest, staples, healthcare and low volatility stocks are actually up as I write this. Within equities, we’re seeing a risk-off reaction, but it’s pretty mild up to this point.
The other big problem is that investors aren’t anywhere near prepared for this. A couple of weeks ago, the markets had a sharp (albeit very quick) risk-off reaction to just the idea of the Bank of Japan loosening up on yield curve control. The VIX is incredibly low. Advisors are dialing up their equity allocations. AI mania is still fresh in everyone’s minds. We’re just entering the time of year where volatility traditionally starts ramping up. All of the signs of overconfidence are there and conditions for an adverse event seem to have gotten a lot higher in just the past week and that’s not even considering the impact that the BoJ or the yen might have.
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