Almost every day, there is a new warning about how the United States’ failure to raise the debt ceiling will cause a cataclysmic debt default which will reverberate on the global financial markets.
“Default would cause interest rates to skyrocket,” says the CEA. He would trigger a “economic and financial catastropheaccording to Janet Yellen. “It would have very significant, difficult to predict and likely lasting effects on investors, issuers and markets alike,says Gary Gensler.
Last week the former and current chairman of the Treasury Borrowing Advisory Committee (a club of banks and investment groups that advises the government on its debt issuance) warned that “any delay in the payment of interest or principal by the Treasury would be an event of seismic proportions”:
The role of the Treasury market as the backbone of the entire financial system cannot be overstated. As evidenced in March 2020, the dysfunction in the Treasury market will rapidly spill over into other markets, hurting American consumers, businesses and ordinary citizens alike. The trading and financing of US Treasuries would be challenged, leaving the market without a price curve and causing investors to withdraw from the fixed income and equity markets. Market intermediaries would reduce the provision of liquidity due to increased volatility, increased operational risks and concerns about creditworthiness and the suitability of collateral. The validity of Treasury bills as margin-eligible collateral would be called into question, with devastating consequences for the interest rate, commodity and mortgage derivatives markets.
Basically, cats and dogs living together.
However, things are not that simple, especially when finance and politics collide. As strange as it sounds, you could see Treasuries run out gathering if the US really runs out of money and the debt ceiling is not raised.
Basically, all of the above warnings are probably true, which is why the US government will never default.
As Ajay Rajadhyaksha of Barclays (and ex-TBAC member) wrote in Alphaville earlier this year, the Treasury and the Federal Reserve have already made it clear from previous capping deadlocks that debt service would be prioritized. Republicans have given Democrats political cover to do so proposing a bill which would even force them to do so.
The White House kicked up some dust around this and spoke loudly about the dire dangers of a debt default to put pressure on Republicans. Yellen, for example, argued that “the priority is actually a default value with just another name”.
Except really Truly it is not.
They have been there since 1976 22 US government shutdowns due to shortfalls in US government budget allocations, 10 of which resulted in unpaid furloughs for non-essential federal workers. As incredibly stupid as they were (and annoying/terrible to the people directly concerned) no one was saying it was even remotely similar to a real default of the US Treasury.
So while a crash could conceivably happen if the Treasury doesn’t hold enough tax revenues in reserve to cover all bonds and bills when they mature, the smart money is on the U.S. government to avoid a debt default even after that.”x-date”.
The White House will simply reduce all other expenses – Medicare checks, military salaries, etc. — and will force Republicans to bear the political fallout.
HOWEVER, this would obviously lead to an economic calamity. Wendy Edelberg and Louise Sheiner of the Brookings Institution estimate that immediate spending cuts would be incredibly painful.
If the debt limit is binding and the Treasury has to make interest payments, then other expenses will have to be reduced by about 25% in an average month. This would be necessary because the Congressional Budget Office projects that nearly 25 cents of every dollar of non-interest expenses will be financed through loans in 2023. If the Treasury were to prioritize interest payments as well as Social Security payments, like some commentators they suggested they might, other payments to individuals, businesses and agencies would see even more substantial cuts by about a third.
Ajay argued the economic cost probably wouldn’t be felt right away, because most people who would suddenly lose a check would still feel confident that it will arrive soon anyway. Perhaps. But many federal workers probably don’t have much savings to draw while waiting for their paychecks.
Given the background of already tightening of credit conditionsthe result would be an almost certain, immediate and severe economic recession, deteriorating dramatically every day the government’s faucets run dry.
Now, that would obviously be bad for financial markets in general, but Treasuries themselves are likely to rally.
First, a US recession will help contain inflation further and could prompt the Fed to reverse some of its rate cuts, and the safety of Treasuries is pretty appealing when stocks puke.
Second, the safety of Treasuries will have effectively been jeopardized by the whole debacle, with the US government demonstrating that it would rather withhold payments to sick grandmothers and disabled soldiers than bondholders. That’s a pretty powerful signal.
Thus, the end result of crossing date X without a debt ceiling agreement might look similar to what we saw after S&P downgraded the US credit rating in 2011: a perverse but powerful Treasury rally. Markets move in mysterious ways.
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