Bullish sentiment returns

This week will be remembered as the time the US step back from the brink to avoid a technical default, and in doing so saved the world from another recession.

At least that was the conventional wisdom put forward by vocal sections of the commentariat. But the markets never believed the doomsday scenario would happen. Even with one day left until the Treasury's October 17 debt ceiling deadline and a deal still not agreed, credit markets were remarkably placid.

The Markit CDX.NA.IG index was trading at 73.5bps on October 16, some 24bps tighter than the levels reached at the peak of the concerns around QE tapering in June.

But why were the markets so calm on the eve of the world's biggest debtor potentially defaulting? The answer is that, despite the best efforts of incalcitrant Republican congressmen, the US government was always likely to meet its obligations. The market expected a deal to be struck at the 11th hour, and that is exactly what happened.

However, one area of the credit market did show signs of stress: the US sovereign CDS. In the run-up to the deadline, the five-year contract hit 40bps, nearly double where it was trading in September. Movements in the one-year contract were even more extreme.

A few days before the impasse was broken, spreads widened beyond 70bps. To put this in context, in mid-September the one-year was being quoted at just 5bps. Activity was considerably higher during the fractious period.

However, it should also be noted that US sovereign CDS are not as liquid as some other sovereigns such as Italy and Spain. Bid/ask spreads in the one-year could be as wide as 15bps, making it difficult to profit from relative value trades.

So was the political crisis unimportant from an economic perspective? Not quite. The uncertainty has probably affected consumer and business confidence, which will have an impact on growth. And we may experience d"j" vu in Q1 next year.

The deal agreed only raises the debt ceiling until February 7th. Hopefully Congress has seen the error of its ways and will be more open to compromise next time around. But politicians have a nasty habit of not meeting even the lowest of expectations.

In the meantime, the piecemeal resolution of the debt ceiling debate may give us the opportunity to focus on fundamentals such as economic data and corporate profitability. Next week will see the delayed publication of the September non-farm payrolls report, though there are serious doubts about the data's accuracy given the government shutdown.

Earnings have so far been solid, with bellwethers such as IBM and General Electric beating expectations. Profits have surprised on the upside more often that revenues and it will be interesting to see if this trend continues throughout earnings season.

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