Headlines have been warning for weeks that the US might default on its debt. The negotiations have become contentious, with a deadline that could come as soon as June 1.
Because Treasuries are the backbone of the global financial system – the “risk-free” asset on which everything else depends – the consequences of a US debt default would be dire, perhaps truly catastrophic.
But how likely is any of this to actually happen?
Both President Biden and House Speaker Kevin McCarthy say they understand a default would be a disaster, but negotiations stalled on Friday and until legislation to raise the debt ceiling is enacted, the outcome is uncertain. And the markets weigh the possibilities closely.
In short, they expect the most likely default wont happens, but they nonetheless suggest that disaster is still very possible, with the odds adjusting quickly as the news changes. If a final solution is not reached soon, the relative calm that prevailed in the markets could quickly collapse.
I noted last week that the cost of insuring against default in the US had risen. While the impasse over the debt ceiling looms, the US in the $30 trillion market of default swaps is seen as a riskier borrower than countries like Bulgaria, Croatia, Greece, Mexico and the Philippines. Compared to Germany, the cost of insuring US debt is about 50 times more.
But as many readers have pointed out, I haven’t said what the numbers tell us about how risky US bonds are. This is not a trivial matter. So here’s a closer look.
What is at stake
While politicians in Washington talk about the government’s possible breach of the debt ceiling, preparations are under way on Wall Street and in US government agencies for a wide range of alarming emergencies.
Even enumerating the possible effects of default is disturbing. They can range from a containable event, consisting of a missed payment of certain Treasury bonds affecting a relatively small number of creditors, to something more catastrophic: the suspension of all Social Security checks and debt payments by the US government, accompanied by a sudden collapse of global markets and a recession.
As former Treasury Secretary Jacob Lew said last month at a meeting of the Council on Foreign Relations, “I think it’s pretty safe to say that if we default, that makes the odds of a recession almost certain.”
What do treasury rates tell us?
Pricing of short-term Treasury notes reveals that traders believe there is a reasonable probability that the US Treasury will miss an interest or principal payment on securities due in early June. That’s when Treasury Secretary Janet L. Yellen said the US is likely to exhaust all “extraordinary measures” that have kept government borrowing under the debt ceiling.
Concern about what might happen in the early days of June is the main reason for the anomaly in Treasury yields. Money market fund managers, worried about a possible default, are shunning treasury bills due at that time, slashing rates and raising yields to a level 0.6 percentage point above treasury bills due in July. By August and September, the assumption is that some degree of normalcy will return, and factors such as inflation and the Fed’s interest rate policy regain their usual dominance. Yields for bills that mature later in the summer and early fall are higher than those in July. This style of iron is unusual.
It involves two things. First, the markets believe it He is Real risk of default in early June. Secondly, the possibility of a file long, extended The failure of the United States to pay its bills is seen as very low.
This is because the problem is primarily political, not financial.
The markets would supply the United States government with all the money it needed, if only Congress would give permission to borrow. The treasury market is the deepest and most liquid in the world. Demand for Treasuries is strong and is likely to remain so, as long as US credit is not damaged.
But a US debt default could change all that, and another downgrade of US debt, as was the case in 2011 when the US came close to default, could increase US borrowing costs.
Underlying the dispute is a basic fact: The state spends far more money than it brings in, in taxes and other revenues. To pay off its debts, the government needs to borrow regularly by issuing large amounts of treasury bills. This means a high level of debt.
It’s a fraught issue for many people, including former President Donald J. Trump, who ran massive deficits during his presidency but now calls for deep spending cuts.
Trump said last week during a live interview hosted by CNN that Republicans should insist on cutting billions of dollars in spending now. If the White House doesn’t agree, he said, “you’re going to have to make a default.”
Mr. Biden said long-term financial questions should be dealt with separately from the debt ceiling, which is just a formality. Speaker McCarthy insists that the final deal must include long-term spending cuts.
Most economists say that when borrowed money is used productively and borrowed at a reasonable rate, deficits need not be a problem. Details matter. But paying America’s debt quickly is essential if financial markets are to function properly.
What do credit default swaps say
For now, the stock market and the broader bond market treat debt ceiling negotiations as a non-event. Other issues dominate: persistent inflation, rising interest rates, bank failures, and the prospect of an imminent recession pivoted by the Federal Reserve, after tightening financial conditions for more than a year.
The debt-ceiling impasse in summer 2011 was different. Then the shares fell sharply.
There hasn’t been any similar action in the stock market yet, and that may be partly because the CDS market views the current situation as less dire than the 2011 crisis.
Credit default swaps are a form of insurance. When the prices or “spreads” of these securities go up, it reflects the market’s view that the underlying bond, in this case, Treasuries, has become riskier. These differences can be used to derive accurate predictions about the default,
At the worst point in 2011, pricing of swaps had a 6.9 percent probability of default on US debt, according to Andy Sparks, managing director and head of portfolio management research at MSCI, the financial services firm. This year, the worst prediction came from the swaps market around May 11, when Mr. Trump made his remarks. The default probability was 4.2 percent after that. Before news of a hitch in the negotiations on Friday, it was hovering around 3.6 percent.
This is a massive increase since January, when the hypothetical probability was close to zero. But while swap spreads are now much wider for Treasuries than they were in 2011, savvy market participants know that when calculating implied default probabilities, another important factor matters as well: the price of the underlying bond.
This is often misunderstood, as Mr. Sparks has shown. “It is important to realize that spread is only one part of calculating probability,” he said.
It’s shaky, but important: Because inflation is higher and yields are higher, bond prices, which move in the opposite direction, are much lower than they were in 2011 for bonds of similar duration. With lower prices today, the default probability is lower than it was in 2011. , although the swap spreads are wider.
In short, the CDS market is saying that investors should worry about defaults — but maybe not worry too much, at least not yet.
Forecast market forecast
A simpler, smaller market gives a higher probability of default, about 10 percent. This is Kalshi Prediction Market. His market reflects “the views of Main Street, not just Wall Street, which is everything you get from the CDS market,” Tarek Mansour, founder of Kalshi, told me.
Kalshi asks a simple question: Will the United States default on its debt at the end of the calendar year? For a small fee, anyone can bet on this “event hold”. Kalshi has a good track record of forecasting inflation and interest rates, and I find his data interesting, though not the last word.
What is the real possibility of a US debt default? Looking at recent history, I would simply say that although the chance of a major disaster occurring is relatively small, it is large enough to prepare for it.
I keep a lot of money in safe places in case of turmoil, but I invest for the long term. Certainly, do not panic if the stock market drops sharply. This could be a buying opportunity since stocks have always been rising after previous debt ceiling fears.
With a little luck, there will be agreement in Washington, and these concerns will become moot. Let’s hope there is no need for a new chapter in the history of political dysfunction.
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