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The U.S. Debt Ceiling. The debt limit, aka the debit ceiling, is the total amount of money that Congress has authorized the U.S. government to borrow. In order to increase the debt limit, the legislative cap must be raised by a majority vote in both the House and Senate. Congress is currently negotiating the debt limit because Republicans have a majority in the House and Democrats have a majority in the Senate and control the Presidency. If the debt limit is not eventually raised or suspended, the U.S. Treasury would likely face a funding crisis that could impact a range of federal spending commitments. Though this scenario is unlikely, there are potential consequences to think through.

We should contemplate three scenarios: (1) a non-event where Congress passes a bill before any undue market stress (low likelihood with minimal impact); (2) temporary financial stress until the current political standoff is broken (high likelihood with medium impact); and (3) a non-resolution leading to a U.S. default and extreme financial stress (low likelihood with significant impact). Analysts then assign a probability to each scenario and discuss positioning. In our view, it is all content for content's sake. Investors feel like they always need to be analyzing something to justify their current positioning, but very few investors act on the analysis. In the end, the analysis and event are simply noise. We have no reason to expect anything different this time.

Failure to raise or suspend the U.S. debt limit could strain financial markets. It is difficult to predict the exact outcome, but potential strains include falling asset prices, a global recession, a weaker USD, a U.S. credit rating downgrade, and a delay or impairment in government functions and services, such as social security checks, salary payments, and national park operations. In our view, the most worrisome risk is a downgrade of the U.S. government's credit rating, which could happen even if a hard default does not occur (i.e., S&P's downgrade in 2011).  It would call into question the 'full faith and credit' of the U.S. government and likely increase Treasury yields across the curve. An increase in Treasury yields, which are often used as the risk-free rate to price loans and other credit securities, would flow through to businesses and individuals in the form of higher borrowing costs.

We are monitoring debt limit negotiations, but we are more focused on the long-term, such as corporate earnings, economic activity, etc. Debt negotiations are a big event with significant potential implications for financial markets, and we acknowledge negotiations will grab headlines, impact the narrative, and drive near-term returns and volatility. However, we do not expect to make any adjustments to the ETF Asset Allocation Models, which are already defensively positioned in line with our risk-off macro view. It is impractical to position entire portfolios for a tail risk, such as a hard U.S. default, given tail risks are by definition a low probability event.

The Opportunity. We are more inclined to take advantage of temporary dislocations in financial markets. As an example, Treasury yields rose sharply this week. The 2Y yield increased +0.25% this week, which represents a +3.4 stdev move compared to the last decade of weekly 2Y yield moves. Likewise, the 5Y yield rose +0.23%, which represents a +2.2 stdev move compared to the last decade of weekly 5Y yield moves. Both the 2Y and 5Y increases are statistically significant and indicate investors are already pushing up the U.S.'s borrowing costs as debt limit negotiations play out. While we continue to favor Long Duration to protect against macro stress, the front end of the Treasury yield curve looks temporarily cheap if you are looking for a tactical portfolio opportunity. Tactically shortening duration would accomplish three goals: (1) expresses a view the U.S. is unlikely to experience a hard default, (2) expresses a view the Fed is approaching its final rate hike, and (3) positions for rate cuts, which even though we expect will not happen until 2024 would push yields lower and bond prices higher on the front end of the curve. Unlike credit, there are no clear equity adjustments to make given a default would weigh on equity prices and we are already defensively positioned.