The US debt limit has been reached and the Treasury is finding ways to provide cash. After running out of maneuvers, what once seemed unfathomable could become reality: a US default.
what happened after that?
The long-term effects are difficult to fully predict: from shock waves in financial markets to bankruptcies and recessions and the potential irreversible damage to a nation’s long-standing role at the center of the global economy.
The probability of default remains low, at least based on assurances from opposition lawmakers of a deal to raise or suspend the debt limit and the long odds involved with trading in certain financial markets. But as the day approaches when the United States begins to run out of cash to pay its bills—which could be as soon as June 1st—investors, executives, and economists around the world are juggling what might happen immediately before, during, and after, spawning contingency plans and baffling. regarding rules and procedures are largely untested.
“We are navigating uncharted waters,” said Andy Sparks, head of portfolio management research at MSCI, which creates indices that track a wide range of financial assets, including in the treasury market.
On the cusp of default, the “horror scenario” emerges.
Some corners of the financial markets have already begun to tremble, but those ripples pale in comparison to the tidal wave that is building as default approaches. The $24 trillion US Treasury market is the main source of funding for the government as well as the largest debt market in the world.
The treasury market is the backbone of the financial system, embedded in everything from mortgage rates to the dollar, the most widely used currency in the world. Sometimes, treasury debt is treated as the cash equivalent because of the guarantee of creditworthiness of the government.
Shattering confidence in such a deeply entrenched market would have effects that are difficult to quantify. Most agree, however, that a default would be “catastrophic,” said Calvin Norris, portfolio manager and interest rate strategist at Aegon Asset Management. “That would be a terrifying scenario.”
Missed payments lead to a trading frenzy as the markets begin to crash.
The government pays its debts through banks that are members of the federal payment system called Fedwire. These payments then flow through the plumbing in the market, eventually ending up in the accounts of debt holders, including individual savers, pension funds, insurance companies, and central banks.
If the Treasury wants to change the date on which it pays back to investors, it will need to notify Fedwire the day before a payment is due, so that investors know the government was about to default the night before that happened.
There is more than $1 trillion in Treasury debt due between May 31 and the end of June that could be refinanced to avoid default, according to analysts at TD Securities. There are also $13.6 billion in interest payments due, spread over 11 dates; That means 11 different opportunities for the government to miss a payment over the course of the next month.
Fedwire, the payment system, closes at 4:30pm. If no payment is due by this time, at the latest, the markets will start crashing.
Stocks, corporate debt, and the value of the dollar are likely to fall. The fluctuations can be extreme, not just in the United States but all over the world. In 2011, when lawmakers struck a last-minute deal to avoid violating the debt limit, the S&P 500 fell 17 percent in just over two weeks. The reaction after default may be more severe.
Demand for some Treasuries may be higher than expected. Investors are likely to dump any debt with payments due soon – for example, some money market funds have already shifted their holdings away from Treasuries due in June – and buy other Treasuries with payments due in the future, still viewing them as a haven. in a period of stress.
A series of rating downgrades is creating a “craze” for bondholders.
Joydeep Mukherji, lead U.S. credit ratings analyst at S&P Global Ratings, said a missed payment would result in the government being deemed to be in “selective default”, in which it has opted to back out of some payments but is expected to continue paying other debts. Fitch Ratings also said it would downgrade the government’s rating in a similar manner. Such ratings are usually assigned to vulnerable companies and government borrowers.
The other major ratings agency, Moody’s, said that if the Treasury missed a single interest payment, its credit rating would be downgraded by a notch, just below its current higher rating. Failure to make a second interest payment may result in another reduction.
Moody’s noted that a large number of government-related issuers could also suffer a downgrade, from agencies that prop up the mortgage market to hospitals, government contractors, railroads, energy utilities and defense companies that depend on government money. It would also include foreign governments with guarantees on their debts from the United States, such as Israel.
Some fund managers are particularly sensitive to ratings downgrades, and may have to sell their Treasury holdings to meet rules about the minimum debt ratings they are allowed to hold, lowering their rates.
“I’m afraid that in addition to first-order madness, there is second-order madness as well: For example, if you downgrade two of the three major rating agencies, you’re going to have a bunch of financial institutions that can’t hold on to this,” said Austin Goolsby, president of the Reserve Bank. The Chicago Fed, at an event in Florida on Tuesday night.
The plumbing of the financial system freezes, making trading more expensive and difficult.
Most importantly, defaulting on a single government bill, bond, or bond does not result in a default on all government debt, known as a “cross default,” according to the Securities Industry and Financial Markets Association, an industry group. This means that the majority of government debt will remain current.
That should limit the impact on markets that rely on Treasury debt for collateral, such as trillions of dollars in derivatives contracts and short-term loans called repurchase agreements.
However, any collateral affected by default must be replaced. CME Group, a large derivatives clearinghouse, said that while it has no plans to do so, it may prevent the use of short-term Treasury notes as collateral, or apply discounts to the value of certain assets used to secure transactions.
There is a risk of the financial system’s pipes freezing, as investors rush to reshuffle their portfolios while the big banks that facilitate trading back out of the market, making it more difficult to buy and sell any asset.
Amid the turmoil in the days following a default, some investors may be in for a big windfall. After a three-day grace period, about $12 billion in credit default swaps, a type of bond default protection, may be triggered. The decision on payments is made by an industry committee that includes major banks and fund managers.
The nation’s global financial reputation is permanently diminishing.
As the panic subsides, confidence in the nation’s primary role in the global economy may change permanently.
Foreign investors and governments own $7.6 trillion, or 31 percent, of total Treasury debt, making it vital to the favorable financing conditions that the US government has long enjoyed.
But after a default, the perceived risk of owning Treasuries can rise, making it more expensive for the government to borrow for the foreseeable future. The central role of the dollar in global trade may be undermined.
Higher government borrowing costs will also make it more expensive for companies to issue bonds and obtain loans, as well as raise interest rates for consumers who take out mortgages or use credit cards.
Economically, according to White House projections, even a brief default would result in the loss of half a million jobs and a rather shallow recession. A prolonged default would push those figures into eight million job losses and a severe recession, with the economy contracting more than 6 percent.
These potential costs – not generally known but widely believed to be enormous – are what many believe will motivate lawmakers to reach an agreement on the debt limit. “Every leader in the room understands the consequences if we fail to pay our bills,” President Biden said in a speech on Wednesday, as negotiations between Democrats and Republicans intensified. “The nation has never defaulted on its debt and never will,” he added.
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