'Market instability' possible before last-minute debt ceiling deal, JPMorgan says

Published Mon, May 22 202311:30 AM EDTUpdated Mon, May 22 202312:24 PM EDT

Jesse Pound @/in/jesse-pound @jesserpound

The looming potential of a federal debt default could soon cause a sharp increase in fear in the stock market, according to JPMorgan Chase. Political leaders were set to meet again in person Monday, but time is running out before a tentative early June deadline. The market is not currently pricing in the possibility of a negotiation that goes down to the wire, JPMorgan strategist Dubravko Lakos-Bujas said in a note to clients. "Our base case remains that the debt ceiling ultimately does get lifted/suspended though the journey to that end could be at the eleventh hour and drive significantly higher market instability than appreciated by the market currently," Lakos-Bujas wrote. The note points out the economic and market backdrop is very different in 2023 than it was during a similar showdown in 2011. In 2011, the Federal Reserve's benchmark lending rate was hovering near zero and the economy was in the early stages of a long recovery. But in 2023, the Fed has hiked its funds rate above 5% and the economy is showing signs of slowing down. These factors "point to a sharper repricing of risk today vs 2011 if the default risk rises," Lakos-Bujas said. "There are two major investment implications related to the debt ceiling and federal spending: 1) the potential for a violent riskoff move in equities as we get closer to the projected X-date of early June without a broadly supported resolution; and 2) the potential for Federal spending cuts across key Biden legislative priorities (e.g. IRA, CHIPS, etc.) as a consequence of partial/comprehensive debt ceiling deal and/or Federal budget negotiation in the fall of this year," Lakos-Bujas wrote. One way for investors to guard against a sharp move in stocks is to buy call spreads on the CBOE Volatility Index (VIX) , often called Wall Street's fear index. A call spread is an option that effectively serves as buying one call option close to the current level of the VIX contract and selling another call option that is further out of the money. The strategy would let the investor benefit from a rise in volatility, though the upside is capped in the event of a dramatic rise that triggers the second call option. The VIX was trading at about 17 Monday, near its lowest level of the past year. The index briefly traded above 30 in March at the height of the bank crisis triggered by Silicon Valley's failure and hit a record high of more than 85 during the Covid sell-off in 2020. .VIX 1Y mountain The Cboe Volatility Index is trading near its lowest level of the past year. JPMorgan recommended buying 25 to 35 call spreads on the VIX that expire in June. For investors looking for additional downside protection, JPMorgan also highlighted put options on the small-cap Russell 2000 Index. — CNBC's Michael Bloom contributed reporting.