There’s “neon swan” potential lurking in America’s debt ceiling crisis.

Notwithstanding one former president’s unorthodox views on the matter, most believe a US default would be unequivocally and unavoidably disastrous, and that such a catastrophe, were it to occur, would risk transforming recent adverse developments in the banking sector into an overlapping crisis.

If a worst-case scenario were to unfold, the Fed would pretty clearly be compelled to cut rates, which explains the persistence of rate cut pricing for the back half of 2023.

But just because you can explain that pricing doesn’t mean it can’t (or shouldn’t) be faded, particularly when the justification is a neon swan, something which, by definition, is unlikely to realize.

If you ask Nomura’s Charlie McElligott, there are two reasons virtually no one wants to aggressively fade the Fed cut pricing. “Few in macro have the PNL to go splashy or brave right now due to this grinding ‘chop’ following the excruciating front-end stop-outs / stop-ins of March, and now, reversals in so many other crowded trades,” he said Friday, before identifying what he believes is a more important factor. “Very few have the risk rope to effectively be ‘short the tail’ of either a debt ceiling accident, a regional banks escalatory accident and/or a hard landing,” he wrote.

Here’s the thing, though: The odds of the debt ceiling can getting kicked down the road are far higher than the odds of a default. Just ask Mitch McConnell, who has “some” experience in D.C. gridlock and brinksmanship born of partisan rancor.

If (when) that happens — whether as a result of a short-term Band-Aid, a year-long truce or, God forbid for the equity shorts and rates longs, some kind of actual, bipartisan solution — a lot of hedges / tail-risk wagers will look vulnerable, and not just in rates.

“Equities investors are being forced to hedge these latent risks, as shown through exceptionally strong VIX call demand which is driving vol of vol uncomfortably higher, as well as the obvious surge in S&P skew and especially put skew,” McElligott went on.

This sets up some potential fireworks. The overnight removal of the debt ceiling overhang could pretty easily trigger a knee-jerk reaction across rates and equities that would jeopardize bullish bets in the former and downside hedges in the latter.

“Even just a temporary solve for the debt ceiling [could act] as a pressure release valve for the Fed’s risk of being ‘forced into’ the market-implied cut pricing,” Charlie said, noting that those front-end trades may need to be “scaled back significantly, or erased altogether” in a scenario where the debt ceiling risk is removed from the board.

That’s all the more true given the Fed’s desire to hold terminal at a time when the incoming macro signals are likely to include curveballs, even if the balance of the data continues to suggest the disinflation process is proceeding. One such curveball came from Friday’s lone notable US data release, which found longer-term inflation expectations in the University of Michigan survey matching the highest since 2008.