Mthe ost At the time, the impossibility of the US defaulting on its sovereign bonds was taken as a fundamental axiom of the financial system. The country issues the world’s reserve currency, so investors are always ready to lend it money. And if you’re able to borrow more, you can pay down your loans.
Yet Washington is once again reminding the world that, through sheer dogma, a default is indeed possible. From time to time—as in 2011, 2013, and today—the US falls within its “debt ceiling”, a political device that puts a hard limit (currently of $31.4trn, or 117%). Gross Domestic Product) on gross government borrowing. Congress must then agree to raise or waive the limits to prevent the Treasury from failing to make bond payments or meet spending obligations. This time Treasury Secretary Janet Yellen has warned that the government may run out of cash and accounting maneuvers by June 1. And so on May 9, congressional leaders gathered in the Oval Office with President Joe Biden for the first phase of talks. They are far away from the deal.
The stage is thus set for a game of fractiousness in which a Republican-controlled Congress tries to extract concessions from Mr. Biden, as the country’s credibility hangs in the balance. Both sides will almost certainly find a way to avoid catastrophe. But as Washington’s staring contest intensifies, Wall Street’s finest are unwilling to get involved. The slightest hint of default has forced traders to look for ways to protect their investments.
To understand why, consider what a default would mean. short-term treasury, or “Tea-Bills”, are the closest thing to a risk-free asset. This makes them suitable for corporate cash managers (who want ultra-safe returns) and any trader who needs to post collateral (which must retain its value and be easy to sell )’s favorite. If the government cracks down on corporate treasurers, companies will default on payments to each other and the wheels of commerce will come to a screeching halt. Banish the collateral of traders, and financial institutions of all stripes will Contracts will begin to diverge, causing chaos in global markets.
Small wonder that investors are rushing to protect themselves. clamor for TeaBills maturing before any potential defaults have led to huge volatility in the yield of the world’s safest asset. The yield on one-month bills stood at 4.7% in early April. It fell to 3.4% over the next three weeks, even as the Federal Reserve prepared to raise its interest rate to 5-5.25%. But the one-month bill now matures after June 1, when the Treasury would have exhausted its cash. And so as demand has subsided, their yield has risen by more than two percent in just a few weeks. One trading boss describes how his team tried to manually override their settlement software to ensure that bills maturing without payment didn’t disappear from the system.
Long-term Treasuries seem safe so far, under the assumption that a true default would shock politicians from their obstinacy, and recover quickly. Yet they are not immune. The cost of insuring five-year Treasuries against default, once the very definition of throwing money away, has quadrupled over the past 12 months (a fact partly explained by a lack of market liquidity).
what next? If You Thought There Was No Chance of Paying Attention to Washington’s Precipitation, Now Is the Time Tea-Sell worthless bond insurance to the bills and nerves at a discount. But even if you think so, you can stop. Since the Treasury would have run its cash reserves down to almost nothing, there would be a deal followed by a glut of issuing to rebuild the buffer. Even the best-case scenario, in other words, would drain liquidity from the market and could push yields higher.
Meanwhile, the stock market is looking volatile anyhow. on analysts pimcoA property manager, notes that over the past dozen years, s & P The 500 Index has fallen an average of 6.5% in the month leading up to the debt-only deadline — even though they’ve always been met. This would fare very poorly under a default. In 2013, during the last debt-limit impasse, Fed officials simulated the effects of a month-long default. He predicted that share prices would fall by 30% and the dollar by 10%.
Meanwhile, traders are expected to grapple even more. US politics will block an early deal, and that may well force markets to panic. The default remains the least likely result. But as investors are acutely aware, this is no longer implausible.