What the Markets Are Telling Us About the Debt Ceiling

For weeks, headlines have warned of a possible default by the United States. Negotiations are ongoing, but the deadline could be as early as June 1.

Because government bonds are the linchpin of the global financial system and the underlying “risk-free” assets of everything else, the impact of a US debt default would be the worst and perhaps truly devastating.

But how likely is it that something like this actually happens?

Both President Biden and House Speaker Kevin McCarthy say they know a default would be catastrophic and don’t expect it to happen, but until legislation to raise the debt ceiling is enacted, the consequences are likely to continue. is opaque. And the market is carefully weighing that possibility.

In a nutshell, they predict that default will most likely occur won’t But they still suggest that the odds are adjusting rapidly as the news changes, and that a catastrophic event is still quite possible. If no final solution is forthcoming, the relative calm prevailing in the market could quickly collapse.

Last week, I pointed out that the cost of insurance against default in the United States has skyrocketed. As the impasse over the debt ceiling looms, the U.S. is seen as: $30 trillion credit default swap market It is listed as a higher risk borrower than countries such as Bulgaria, Croatia, Greece, Mexico and the Philippines. Compared to Germany, insurance costs for US government bonds are about 50 times higher.

But, as some readers have pointed out, I didn’t say what the numbers say about how risky Treasuries have become. This is no trifle. Let’s take a closer look here.

As politicians negotiate in Washington to avoid the government’s debt ceiling violations, Wall Street and US government agencies are gearing up for a variety of disturbing events.

Just listing the possible effects of defaults is worrisome. They range from controllable events such as nonpayment of certain Treasury Bills affecting a fairly small number of creditors to far more catastrophic events such as suspension of all Social Security checks and debt payments by the U.S. government. It can be wide-ranging. by a sudden global market collapse and recession.

As Former Treasury Secretary Jacob Lu Said At a Council on Foreign Relations meeting last month, he said: “I think it’s fair to say that if we default on our debt, we’re almost certain we’re going into a recession.”

Given the current pricing of short-term Treasury bills, traders believe it’s entirely possible that the U.S. Treasury will default on interest or principal payments on securities maturing in early June. I understand. That’s when Treasury Secretary Janet L. Yellen said the United States would likely exhaust all the “temporary measures” that have kept government borrowing below the debt ceiling.

Concern about what will happen in early June is the main reason for the Treasury bill yield anomaly. Money market fund managers, nervous about the possibility of default, have avoided issuing Treasury bills that mature at that time, lowering prices and pushing yields to maturity in July. It has pushed up to a level 0.6 percentage points higher than Treasury bills. By August-September, some degree of normalcy should return, with factors such as inflation and the Fed’s interest rate policy regaining their customary primacy. Yields on bills that mature in late summer or early fall are higher than those in July. This barbell pattern is unusual.

It means two things.First, the market believes that teeth There is a real risk of default in early June. Secondly, there are the following possibilities: linger It is considered extremely unlikely that the United States will not pay its bills.

Because the issue is fundamentally political, not financial.

The market will provide the U.S. government with all the money it needs if only Congress gave it permission to borrow. The government bond market is the deepest and most liquid market in the world. Demand for U.S. Treasuries is strong and likely to continue unless U.S. credit is undermined.

But a U.S. default could change all that, and another downgrade of U.S. debt, as it did near default in 2011, could increase U.S. borrowing costs. have a nature.

Underlying this controversy is a basic reality. So the country is spending far more money in taxes and other revenues than it is coming in. To service its debt, the government needs to borrow regularly by issuing large amounts of Treasury bills. This means higher debt levels.

This is a serious problem for many, including former President Donald J. Trump, who ran huge budget deficits during his presidency but now calls for drastic spending cuts.

Trump: Republicans Should Call for Trillions of Dollars in Spending Cuts Now Said At a live town hall hosted by CNN last week. If the White House disagrees, he said, “we will have to default.”

Biden has said long-term fiscal issues should be treated separately from the debt ceiling, but that’s only a formality. Nonetheless, negotiations are ongoing and McCarthy insists the final deal must include long-term spending cuts.

Most economists say deficits shouldn’t be a problem if borrowed money is used productively and can be borrowed at reasonable interest rates. Details matter. However, prompt repayment of US debt is essential for the proper functioning of financial markets.

For now, the stock market and broader bond market are treating the debt ceiling negotiations as if nothing happened. Other issues also dominate, including persistent inflation, high interest rates, bank failures, the possibility of an imminent recession, and the possibility of a policy reversal by the Federal Reserve after more than a year of monetary tightening. It’s becoming

It was different in the summer of 2011 when we got stuck at the debt ceiling. After that, the stock price plummeted.

We haven’t seen a similar move in the stock market so far, which could be partly because the credit default swap market sees the current situation as less risky than the 2011 financial crisis. .

A credit default swap is a form of insurance. As the prices, or ‘spreads’, of these securities rise, they reflect the market’s view that the underlying bonds, in this case US Treasuries, have become more risky. These spreads can be used to derive accurate predictions about defaults.

At its worst in 2011, swap pricing implied a 6.9% chance of U.S. debt default, according to Reuters. Andy SparksManaging Director and Head of Portfolio Management Research MSCI, a financial services company. The most dire forecast for the swaps market this year came around May 11, when Mr. Trump made his remarks. At that time, the default probability reached 4.2 percent. It is hovering around 3.7% following reports of progress in negotiations.

That’s the biggest increase since January, when default probabilities were near zero. But with swap spreads on U.S. Treasuries now significantly wider than they were in 2011, prudent market participants should consider another important factor when calculating implied default probabilities: the price of the underlying bond. I know that other factors are also important.

As Sparks explained, this is often misunderstood. “It’s important to realize that the spread is only part of the probability calculation,” he said.

This is strange, but important. With inflation skyrocketing and yields rising, reverse-moving bond prices are much lower than comparable duration bonds in 2011. With lower prices today, the probability of default is lower than it was then. 2011 despite widening swap spreads.

So, the credit default swap market says investors should worry about defaults, but maybe they don’t have to worry too much, at least for now.

Because the market is simpler and smaller, the probability of default is higher at around 9%.this is Calsi prediction market. Karsi founder Tarek Mansour told me that his market “reflects the voice of Main Street, not just Wall Street. That’s all you get from the credit default swap market.” .

Karsi asks a naive question: Will the US default by the end of the calendar year? Anyone can bet on this “event contract” for a small fee. Karsi has an excellent record on forecasting inflation and interest rates, and while not the final word, I think that data is interesting.

What are the actual odds of a US debt default? Given recent history, it’s easy to say that the odds of a major catastrophe happening are fairly small, but big enough to be prepared for.

I keep a lot of cash in a safe place just in case something goes wrong, but it’s a long-term investment. Indeed, there is no need to panic when the stock market plummets. It could even be a buying opportunity, as stocks have always risen after previous debt ceiling fears.

With a little luck, an agreement in Washington will put an end to these concerns. Let’s hope we don’t have to add another chapter to the history of political dysfunction.

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