For weeks, the headlines have been warning of a possible US default. The negotiations are controversial, the deadline could be as early as June 1st.
Since Treasuries are the linchpin of the world financial system – the “risk-free” asset on which everything else is based – the consequences of a US debt default would be dire, perhaps even catastrophic.
But how likely is it that something like this actually happens?
President Biden and Speaker Kevin McCarthy both say they understand a default would be catastrophic, but negotiations stalled on Friday and the outcome is uncertain until legislation raising the debt ceiling is passed. And the markets are weighing the odds carefully.
In short, they predict that a default is unlikely to occur, but nevertheless caution that disaster is still all too possible and probabilities adjust quickly as the news changes. If a definitive solution is not found soon, the relative calm that has prevailed in the markets could quickly dissipate.
I noticed last week that the cost of insurance against a US default has skyrocketed. As the debt ceiling impasse looms, the United States is seen as a riskier borrower than countries like Bulgaria, Croatia, Greece, Mexico and the Philippines in the $30 trillion credit default swap market. Compared to Germany, the cost of hedging US debt is about 50 times higher.
But as several readers pointed out, I didn’t say what the numbers tell us about how risky US bonds have become. This is not a trivial matter. So here’s a closer look.
What’s at stake
As politicians in Washington discuss the possibility of the government breaching the debt ceiling, Wall Street and the US government agencies brace for a host of troubling contingencies.
Just listing the potential impact of a default is unsettling. They could range from a containable event consisting of a missed payment of a particular Treasury bill affecting a relatively small number of creditors to something far more catastrophic: the concomitant suspension of all Social Security checks and debt payments by the United States government by a sudden collapse of world markets and a recession.
As former Treasury Secretary Jacob Lew said at a Council on Foreign Relations meeting last month, “I think it’s safe to say that if we default, the likelihood of a recession is almost certain.”
What Treasury prices tell us
Short-dated government bond pricing shows that traders believe there is a reasonable possibility that the US Treasury will miss interest or principal on securities maturing in early June. At this point, Treasury Secretary Janet L. Yellen says the United States is likely to exhaust any “extraordinary measures” that have kept the national debt below the debt ceiling.
Concerns about what might happen in the first days of June are the main reason behind an anomaly in government bond yields. Money market fund managers, fearful of a possible default, are shunning the government bonds that are due, lowering prices and driving yields to levels 0.6 percentage points higher than government bonds maturing in July. It is expected that by August and September some degree of normality will have returned and factors such as inflation and Fed interest rate policy will regain their accustomed dominance. Yields on notes maturing later in summer and early fall are higher than in July. This barbell pattern is unusual.
It implies two things. First, markets are anticipating that there is a real risk of default in early June. Second, the likelihood that the United States will go unpaid for an extended period of time is considered extremely remote.
That’s because the problem is fundamentally political, not financial.
The markets will provide the United States government with all the money it needs if only Congress authorizes the borrowing. The treasury market is the deepest and most liquid in the world. Demand for government bonds is robust and should remain so as long as US creditworthiness is not impaired.
But a US debt default could change all that, and another US debt downgrade, as happened in 2011 when the United States was on the brink of default, could increase US borrowing costs.
Underlying the dispute is a fundamental reality: the country spends far more money than it collects in taxes and other revenues. In order to pay off its debts, the state has to borrow regularly by issuing large amounts of government bonds. This implies an increasing debt level.
It’s a hot topic for many, including former President Donald J. Trump, who ran huge deficits during his own presidency but is now campaigning for significant spending cuts.
Republicans should now insist on trillions in spending cuts, Mr Trump said during a live CNN Town Hall event last week. If the White House doesn’t agree, he said, “you’ll have to file a default.”
Mr. Biden has said that long-term fiscal issues should be dealt with separately from the debt ceiling, which is merely a formality. Spokesman McCarthy insists any final deal must include long-term spending cuts.
Most economists say that deficits need not be a problem if borrowed money is used productively and borrowed at a reasonable rate. It’s all about the details. However, paying off America’s debts promptly is imperative for the smooth functioning of financial markets.
What Credit Default Swaps Say
Right now, the stock market and the broader bond market are looking at the debt ceiling negotiations as nothing. Other themes dominate: persistent inflation, high interest rates, bank failures, the possibility of an impending recession and a U-turn by the Federal Reserve after more than a year of tightening financial conditions.
The summer 2011 debt ceiling impasse was different. Then stocks fell sharply.
So far there has been no comparable action in equity markets, and that may be partly because the credit default swap market sees the current situation as less risky than the 2011 crisis.
Credit default swaps are a form of insurance. When the prices, or “spreads,” of these securities increase, they reflect the market’s view that the underlying bonds, in this case government bonds, have become riskier. Precise predictions of default can be derived from these spreads,
According to Andy Sparks, managing director and head of portfolio management research at MSCI, the financial services company, swap prices in 2011 implied a 6.9 percent chance of a US debt default. This year, the swap market’s darkest prediction came around May 11, when Mr. Trump made his comments. At that time, the probability of failure was 4.2 percent. Before it was announced on Friday that negotiations had stalled, it was around 3.6 percent.
That’s a huge increase since January, when the probability of default was near zero. But while government bond swap spreads are much wider today than they were in 2011, savvy market participants know that when calculating implied default probabilities, another important factor also matters: the price of the underlying bonds.
This is often misunderstood, as Mr Sparks explained. “It’s important to realize that spread is only part of the probability calculation,” he said.
It’s odd, but important: With inflation soaring and yields rising, bond prices moving in the opposite direction are much lower than bonds of comparable maturity were in 2011. At today’s lower prices, the probability of default is lower than it was in 2011, even if swap spreads are wider.
In short, the credit default swap market says investors should be worried about default — but probably not too worried, at least not quite yet.
The prediction of a prediction market
A simpler and smaller market indicates a higher probability of default of about 10 percent. This is the Kalshi prediction market. Tarek Mansour, one of Kalshi’s founders, told me that his market “reflects the views of Main Street, not just Wall Street, because that’s all you get from the credit default swap market.”
Kalshi asks a simple question: will the United States default on its debt by the end of the calendar year? Anyone can bet on this “event contract” for a small fee. Kalshi has a good track record of predicting inflation and interest rates, and I find his data interesting, if not the last word.
What is the actual probability of a US debt default? Given recent history, I would simply say that while the probability of a major catastrophe is quite small, it is still large enough to prepare for.
I keep enough cash in safe places in case of a disruption, but invest for the long term. Don’t panic if the stock market falls sharply. It could even be a buying opportunity as stocks have consistently rallied following previous debt ceiling fears.
With any luck, there will be an agreement in Washington and these concerns will become obsolete. Let’s hope there is no need for a new chapter in the history of political dysfunction.