Weekly market commentary

U.S. debt stand-off to add to volatility

­Market take

Weekly video_20230515

Kurt Reiman

Opening frame: What’s driving markets? Market take

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The U.S. Treasury hit the debt ceiling in January and is nearing the June date when it may be unable to pay its bills on time. 

Title slide: More volatility ahead from debt showdown

We think the U.S. debt showdown will stoke volatility in financial markets.

Here’s why:

1: Volatile economic regime

The U.S. faced a similar standoff in 2011 amid the euro area debt crisis. Back then policy rates were near zero, deflation risks were emerging and the Fed’s balance sheet was expanding. Today the backdrop is very different.

Bond market volatility has surpassed the 2011 level as markets grapple with central banks’ trade-off to live with some inflation or crush economic activity.

Equity volatility is more muted, but we don’t think stocks are immune – just a few major tech firms drove almost all of this year’s S&P 500 returns.

2: Technical default and credit rating risks

If the debt limit isn’t raised or briefly suspended, the Treasury would be forced to miss payments, even if it prioritized paying bondholders. Credit rating agencies would likely lower the U.S. credit rating like S&P did in 2011.

3: Cautious but eyeing opportunities

We have been positioned defensively as the Fed rapidly hiked interest rates, creating financial cracks. 

Outro frame: Here’s our Market take

We stay cautious and prefer quality within stocks and bonds. And we’re ready to nimbly shift our six-to-12-month views to seize opportunities if risk assets better price in the economic damage we expect.

Closing frame: Read details:

More volatility ahead

We think the U.S. debt limit showdown will spark renewed volatility in markets. That risk reinforces why we stay invested and cautious by going up in quality.

Market backdrop

Stocks were flat last week after U.S. data confirmed core inflation staying high. We think sticky inflation makes Federal Reserve rate cuts later this year unlikely.

Week ahead

U.S. industrial production and business survey data due this week should gauge how the Fed’s rate hikes have hurt industrial and business activity.

Negotiations to lift the U.S. debt ceiling are heating up. The Treasury hit the $31.4 trillion “ceiling,” or cap on how much debt it can issue, in January. It may be unable to pay its bills in early June. Even if a deal is struck before then, we expect the debt showdown to stoke market volatility. The bigger story on a six- to 12-month horizon: We think central banks must damage growth to cool inflation in the new regime. We stay invested but cautious as a result, and favor quality assets.

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Volatility brews

Bond and equity implied volatility, 2011-2023

The dark orange line shows that U.S. Treasury bond volatility in 2023 has spiked above the 2011 level when there was a delay in lifting the debt limit amid the euro area debt crisis. The yellow line shows that S&P 500 volatility looks muted compared with 2011 and bond volatility.

Source: BlackRock Investment Institute, with data from Refinitiv Datastream, May 2023. Notes: The chart shows the normalized level of implied volatility for U.S. Treasuries and the S&P 500 in standard deviations as of May 5, 2023. The MOVE index represents U.S. Treasuries implied volatility, while the VIX index represents S&P 500 implied volatility.

A delay in lifting the U.S. debt limit, as well as the euro area debt crisis, spurred a bout of market volatility in 2011. See the chart. U.S. Treasury bill yields seen as the most vulnerable to late payment jumped, and the S&P 500 fell about 17% between July and August 2011. Policy rates were near zero back then, deflation risks were emerging and the Fed balance sheet was expanding. All that provided a cushion. The backdrop is very different today. Bond market volatility has already surpassed the 2011 level (dark orange line) as markets grapple with central banks’ trade-off: either live with some inflation or crush economic activity. Equity volatility is more muted (yellow line). Yet we don’t think stocks have been immune – just a few major tech stocks account for almost all S&P 500 returns this year. Our conclusion: Brace for higher volatility because of the combined effect of debt ceiling concerns and financial cracks from rate hikes.

Invested but cautious

It’s uncertain when exactly the U.S. Treasury will run out of funds to meet its financial obligations – known as the “X date.” Treasury Secretary Janet Yellen has warned that could happen as soon as early June. Conversations about a last-minute deal to raise or suspend the debt ceiling, meaning eliminate it for a brief period, are ongoing as Democrats have so far rebuffed Republicans’ push for spending cuts and other concessions. The Treasury risks a technical default when it temporarily fails to make its bond payments if policymakers don’t strike a deal in time. The Treasury may prioritize paying bondholders over others, but it’s unclear if the Treasury can do so: There is no precedent, and the Treasury lacks the legal authority. Yet there is precedent for credit rating agencies trimming the U.S. top-notch credit rating like S&P did in 2011 – even if a technical default doesn’t happen. That could cause investors to demand more compensation for holding U.S. assets amid higher risk.

Yields for some Treasury bills maturing just after the X date have already started to rise, but risk assets have yet to fully react. Yields for the affected Treasury bills could march higher, and volatility may keep cycling through assets if the debt ceiling is repeatedly suspended.

We stay invested but cautious against this backdrop. We had already been going up in quality and focused on building resilient portfolios as the Fed rapidly hiked rates. We see opportunities to earn attractive income in short-term debt if yields rise more. Investors who don’t need to quickly sell assets can earn attractive income during the debt showdown, in our view, by holding on to at-risk Treasury bills until they mature. Persistent inflation makes inflation-linked bonds attractive, too. Notably, demand for gold has picked up via exchange-traded funds and foreign exchange reserve managers.

Developed market equities remain the bulk of portfolio allocations, even as we underweight them slightly in the short term. We prefer emerging market (EM) stocks in the short term as they benefit from China’s economic restart, EM central banks nearing the end of their hiking cycles and a broadly weaker U.S. dollar. We could consider leaning more into equities overall if debt ceiling volatility and recession create a sharp fall in equity prices.

Our bottom line

The debt ceiling showdown is set to increase the volatility in financial markets that has defined the new regime. Any selloff may cause risk assets to better price in the economic damage we expect from interest rate hikes. We’re ready to shift our views on a six- to 12-month horizon to take advantage of opportunities that may appear.

Market backdrop

Global stocks were largely unchanged last week and bond yields stayed within their range since mid-March. U.S. CPI data showed that core services inflation, excluding shelter, is easing, but core goods prices surprisingly ticked higher. Core inflation still doesn’t look on track to settle near the Fed’s 2% target, making Fed rate cuts this year unlikely, in our view. The Bank of England hiked policy rates to 4.5% as it carries on with its fight against stubborn inflation while growth stagnates.

We’re watching industrial production and business survey data in the U.S. to gauge the damage to activity as higher interest rates tighten financial conditions and cause financial cracks, as seen in bank turmoil. We’re also looking for signs of a sustained rise in Japan inflation that we think may eventually spur a change in ultra-loose policy – and bond volatility.

Week ahead

The chart shows that gold is the best performing asset year-to-date among a selected group of assets, while Brent crude is the worst.

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of May 11, 2023. Notes: The two ends of the bars show the lowest and highest returns at any point in the last 12-months, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.

May 16

U.S. industrial production, retail sales; Germany ZEW economic sentiment

May 18

U.S. Philly Fed Index

May 19

Japan CPI

Investment themes


Pricing the damage

Financial cracks and economic damage are emerging from the fastest rate hiking cycle since the 1980s. What matters: how much damage is in the price and our assessment of market risk sentiment.


Rethinking bonds

We see higher yields, especially in short-term government paper, as a gift to investors after years of being starved of income.


Living with inflation

Central banks are likely to stop their rapid rate hikes when the economic and financial damage becomes clearer, with inflation likely settling above 2% policy targets.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, May 2023

Asset Strategic view Tactical view Commentary
Equities Equities: strategic Overweight +1 Equities: tactical Underweight -1 We are overweight equities in our strategic views as we estimate the overall return of stocks will be greater than fixed-income assets over the coming decade. Valuations on a long horizon do not appear stretched to us. Tactically, we’re underweight DM stocks as central banks’ rate hikes cause financial cracks and economic damage. Corporate earnings expectations have yet to fully reflect even a modest recession. We are overweight EM stocks and have a relative preference due to China’s restart, peaking EM rate cycles and a broadly weaker U.S. dollar.
Credit Credit: strategic Overweight +1 Credit: tactical Underweight +1 Strategically, we are overweight global investment grade but have reduced it given the tightening of spreads in recent months. We are neutral high yield as we see the asset class as more vulnerable to recession risks. Tactically, we’re neutral investment grade due to tightening credit and financial conditions. We’re underweight high yield as we see a recession coming and prefer to be up in quality. We’re overweight local-currency EM debt – we see it as more resilient with monetary policy tightening further along than in DMs.
Government bonds Government bonds: strategic Underweight -1 Government bonds: tactical Underweight -1 We are neutral in our strategic view on government bonds. This reflects an overweight to short-term government bonds and max overweight to inflation-linked bonds. We remain underweight nominal long-term bonds: We think markets are underappreciating the persistence of high inflation and investors likely demanding a higher term premium. Tactically, we are underweight long-dated DM government bonds for the same reason. We favor short-dated government bonds – higher yields now offer attractive income with limited risk from interest rate swings.
Private markets Private markets: strategic Underweight -1 - We’re underweight private growth assets and neutral on private credit, from a starting allocation that is much larger than what most qualified investors hold. Private assets are not immune to higher macro and market volatility or higher rates, and public market selloffs have reduced their relative appeal. Private allocations are long-term commitments, however, and we see opportunities as assets reprice over time. Private markets are a complex asset class not suitable for all investors.

Note: Views are from a U.S. dollar perspective. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular funds, strategy or security.

Our granular views indicate how we think individual assets will perform against broad asset classes. We indicate different levels of conviction.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, May 2023

Legend Granular

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Note: Views are from a U.S. dollar perspective. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.

Jean Boivin
Head – BlackRock Investment Institute
Wei Li
Global Chief Investment Strategist – BlackRock Investment Institute
Alex Brazier
Deputy Head – BlackRock Investment Institute
Kurt Reiman
Senior Strategist for North America – BlackRock Investment Institute