Analysis-Debt ceiling worries bubble up in US stock options market

By Saqib Iqbal Ahmed

NEW YORK (Reuters) – Worries over a debt ceiling showdown are creeping into U.S. options markets, as investors grow increasingly concerned that lawmakers will be unable to hammer out a deal in coming weeks, potentially sparking stock volatility as a key deadline nears.

Although concerns related to raising the $31.4 trillion U.S. debt ceiling have been apparent in Treasury markets for a while, equities markets have been less fazed, with the doggedly holding onto a rally that has seen it gain 6% year-to-date.

In the options market, however, worries are bubbling as some analysts warn the so-called X-date, after which the government is no longer able to pay all its bills, could come in the first half of June.

While most investors still expect lawmakers will avoid a market churning 2011-style standoff, some are now hedging against the volatility that could result if negotiations come down to the wire or fail, sparking what Deutsche Bank (ETR:) analysts said could potentially be “the defining market event of the summer.”

“It’s something that is definitely getting increasing attention,” said Alex Kosoglyadov, managing director of equity derivatives at Nomura.

Elevated concern can be seen in one measure of S&P 500 skew – a gauge of relative demand for put versus call options – that has jumped to a one-year high, driven in part by some large trades that would pay out if equity volatility spiked in coming months, Kosoglyadov said.

Call options convey the right to buy the underlying security at a fixed price in the future, while puts convey the right to sell at a set price. (Graphic: Skew view,

Meanwhile, the volatility term structure – a curve showing the change in expectation for future stock market gyrations – shows the July futures for the Cboe Volatility Index (), often called “Wall Street’s fear gauge”, trading 1.2 points higher than June, the largest gap of any two months between June and December

Market participants also pointed to a single trade last week in which a buyer purchased $16 million in VIX options that would pay out if volatility spiked in June as a likely protection play against debt ceiling-related turmoil.

“While the most probable outcome is a resolution as history dictates, we believe the markets could be increasingly focused on it as a risk if resolution is delayed to the 11th hour,” said Max Grinacoff, equity derivative strategist at BNP Paribas (OTC:).

For now, “people are starting to put it on their radar,” Grinacoff said.

Republican lawmakers who control the U.S. House of Representatives will be tested in coming days to muster the 218 votes needed to adopt a plan to slash spending while raising the debt ceiling, a move they hope will jumpstart talks with President Joe Biden.

The proposal has little chance of passing the Democratic-controlled Senate, and the White House said Tuesday that Biden would veto it if it reached his desk.

U.S. Treasury Secretary Janet Yellen on Tuesday warned that failure by Congress to raise the government’s debt ceiling – and the resulting default – would trigger an “economic catastrophe” that would send interest rates higher for years to come.

AWKWARD TIMING

Legislative standoffs over debt limits this last decade have largely been resolved before they could ripple out into markets. That has not always been the case: A protracted standoff in 2011 prompted Standard & Poor’s to downgrade the U.S. credit rating for the first time, sending financial markets reeling.

This year’s worries come at a sensitive time for stocks, with investors digesting a flare-up of last month’s banking concerns, slowing corporate earnings and worries that the Federal Reserve’s aggressive rate increases have put the economy on course for a recession.

Phil Orlando, chief equity strategist at Federated Hermes (NYSE:), sees a possible debt ceiling fiasco as one possible factor contributing to his forecast for the S&P 500 to fall back to 3,500 this year, putting it some 14% below its current level.

“You are going to have all these fundamental pressures — and then our friends in Washington aren’t going to be able to agree on what to do with the debt ceiling,” he said.

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