This month, global investors face a particular paradox. A modern finance mantra is that Treasuries are “risk-free” assets, implying that it is inconceivable that the US government could default.
But in January, the Treasury breached the debt ceiling by $31.4 billion, capping bond issuance and warned of a crisis unless Congress raises the issue – which Republicans refuse. to do without massive spending cuts. And this week, Janet Yellen, US Treasury Secretary, warned that the funds could be exhausted on June 1st.
So the prices of credit default swaps have now jumped above 165 basis points, suggesting investors fear a low but growing default risk. And while the CDS market is lightly traded, other indicators are also flashing red.
The spread between one- and three-month Treasury bills, say, exceeded 180bp, a record. And Alan Schwartz, Chairman of Guggenheim Partners, said at the Milken conference this week that “short-term treasury yields are higher than corporate [bonds].” This implies that the American C-suite is now considered safer than Uncle Sam. So much for that “risk-free” label.
So what should puzzled observers conclude? There is good news and bad news. To start with the first: the probability of a Treasury default in the short term, according to the classic definition, is still very low, despite the evolution of CDS prices.
That’s partly because American politicians have a long-standing (and shameful) habit of repeatedly flirting with disaster before striking a last-minute deal. And even if it doesn’t happen again now, the Treasury has three options to avoid a technical default if its funds do expire on June 1.
One is to prioritize interest payments, while reducing other budget expenditures. Another is to ignore the legal cap and continue issuing bonds. A third is something like selling a trillion dollar coin to the Federal Reserve, to raise revenue.
However, the bad news is that none of these tactics are easy to organize – or likely to appease investors. If Yellen ignores the congressional debt limit, say, there will be legal challenges. And even if “the prioritization [for interest payments] avoided an immediate fault, damage [to confidence] would be vast, Remarks Bill Dudley, former president of the New York Fed. “Stock and bond prices would fall sharply.”
It would also likely trigger downgrades in credit ratings. One agency, Standard & Poor’s, has already stripped America’s prime rating. However, this had a limited impact as Moody’s and Fitch still retain AAA ratings.
But, if a second downgrade happens now, financial industry protocols will require most asset managers to remove Treasuries from the all-important AAA bucket. This could create unpredictable chain reactions.
So can this be avoided? Maybe. Next week, Joe Biden will meet with congressional leaders, and they could try to hammer out a deal to keep the Treasury running for six months. If so, the next debt ceiling negotiations will take place amid Congressional discussions around the 2024 fiscal budget, potentially creating more bargaining chips. “The right thing to do is a short term [ceiling] increase,” Maya MacGuineas, chair of the Committee for a Responsible Federal Budget, told Milken.
However, Biden is saying in public that he will fight any effort to tie those two talks together — not least because House Republicans say they won’t raise the cap unless Democrats’ favorite spending programs are cut. And Mick Mulvaney, Donald Trump’s former White House budget director, fears far-right Republicans could oust their chairman, Kevin McCarthy, if a deal is reached without such cuts.
“I’m not worried about that cap – I think they’re going to pass something,” Mulvaney observes. “But I’m worried about the next [since] the question is: can McCarthy survive?
Either way, what we desperately need now is not just a short-term ceiling, but a long-term fiscal plan to tackle America’s ever-increasing national debt. . However, that will almost certainly require significant reforms (i.e. cuts) to Social Security and Medicare — an idea both Biden and Trump have ruled out.
Indeed, there is such political polarization that the two sides are unlikely to even create a joint tax reform commission now; or not, unless forced to do so to quell a market panic. Which is not what bondholders (nor Yellen) want to see.
Perhaps this crisis will now occur. And maybe it will even trigger enough humility, or terror, in Congress to start budget talks. After all, as Schwartz notes, the main reason the U.S. government was able to ignore the growing debt burden over the past decade is that ultra-low rates meant that “we were able to have interest charges fixed for 17 years while we have tripled”. our deficit. It is now over.
But the catch is that if the market panic breaks out, it won’t be easy to contain and could create an “economic disaster”. as the White House notes. And “no matter how these [negotiations] play, we have already demonstrated to the world that we are dangerously broken,” laments MacGuineas.
Or to put it another way, the real surprise of 2023 is not that the “risk-free” mantra around Treasuries is cracking – but that it has stuck in place for so long, given America’s political dysfunction. Investors should be worried.
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