Not just default. The US faces problems with any decision on the national debt

Not just defaul USA

There are only a few days before a possible US default – it could happen on 1 June if the country’s authorities do not reach an agreement on the debt ceiling. The White House is negotiating with Republican congressmen who, to approve an increase in the ceiling from the current $31.4 trillion, require a reduction in budget spending.

President Joe Biden, meanwhile, has left for the G7 summit in Hiroshima, Japan, and discussions have stalled in his absence. They were suspended because of “unreasonable” demands from the White House, the Republican deputy speaker of the House of Representatives said on Friday. Biden remains optimistic and expresses confidence that the national debt issue will eventually be successfully resolved after all. However, the potential problems for the US are not limited to default: Bloomberg drew attention to the threat to the US economy which could materialise in case the debt ceiling problem is resolved.

What’s the catch?

As the agency notes, many on Wall Street are predicting that lawmakers will eventually come to an agreement that will probably avert a devastating debt default. But that doesn’t mean the economy will remain unscathed by the Treasury’s intentions to return to “business as usual” as soon as it can increase borrowing.

Ari Bergmann, founder of Penso Advisors, which specialises in hard-to-manage risks, believes the Ministry of Finance will have to struggle to replenish its dwindling cash reserves to maintain its ability to pay its liabilities through Treasury bill sales.

“The supply surge, estimated to be more than $1 trillion by the end of the third quarter, will quickly deplete banking sector liquidity, raise short-term funding rates and “tighten the screws” on the US economy as it is on the verge of recession. Bank of America Corp. estimates it would have the same economic effect as a quarter-point increase in the Fed’s interest rate. Higher borrowing costs from the Federal Reserve’s most aggressive tightening cycle in decades have already affected some firms and held back economic growth. Against this backdrop, Bergmann is particularly wary of a possible move by the Finance Ministry to restore cash, seeing the possibility of a significant reduction in bank reserves,” the agency wrote.

“My biggest concern is that when the debt limit is raised – and I think it will be – you will face a very, very deep and sudden liquidity drain,” Bergmann said. – And we have already seen that this drop in liquidity has a really negative impact on risk assets.”

Experts agree that such a scenario is realistic. They explain that the US Treasury is now constrained by reaching the government debt ceiling and is forced to spend its account balances, which has led to their depletion. In the event of a massive release of government bonds into the market, their yields would rise and free liquidity in the banking system would shrink sharply.

“For our part, we add the prediction that in the event of rising US Treasuries yields, the dollar would strengthen against other currencies. However, also in the event of a US default there is likely to be a global risk-off (flight of investors into defensive assets). Thus, in both cases, the dollar is on the way to strengthening in the short term, while risky assets (equities, commodities, emerging market currencies) are on the way down,” experts make a disappointing conclusion.

Market may not rise if negotiations succeed

Some experts believe that there will not necessarily be a rally in the market after the debt decision. “A big domestic political wrangle” in the US over a ceiling increase, similar to the current one, was already observed in 2011.

“The Republicans, too, pressured Obama from the beginning of the year and eventually agreed on a new ceiling a few days before the deadline, in exchange for budget cuts. That was on 31 July. But did this “relief” lead to the stock market rally that the optimists are now betting on? Not at all – on the contrary, after months of sideways movement (very similar to the current one), the decision led to a classic “sell the fact” and already in August the index lost 15%. I am not claiming that it will be the same now. But blindly betting that there will definitely be a rally after the sovereign debt decision is too reckless,” warned the expert.

Banks could still “crumble”

In addition to the state debt issue, problems in the States are also observed on another “economic front” – the possibility of a banking crisis has not yet receded. Bloomberg has pointed out that, according to Moody’s Analytics, commercial property prices in the US fell in the first quarter for the first time in more than a decade and this raises the risk of increased financial stress in the banking sector.

The decline of less than 1% was driven by declines in the multi-family residential and office building segments. Mark Zandi, chief economist at Moody’s Analytics, believes that a bigger fall of 10% is coming, assuming the US overcomes the recession. If it doesn’t, the downturn could be much worse.

This factor will exacerbate difficulties for banks, which have to struggle to hold deposits in the face of the sharp rise in interest rates over the past year, the agency stresses. Banks accounted for more than 60% of the $3.6 trillion in commercial real estate loans outstanding in the fourth quarter of 2022, with smaller institutions particularly at risk, according to the Fed’s report, excluding farms and residential properties. The magnitude of the property value adjustment could be significant and therefore could lead to credit losses for banks.

Paul Ashworth, Capital Economics’ chief economist for North America, sees the risk of a “doom loop” developing, with banks’ credit contraction leading to a steeper fall in commercial property prices, which in turn would lead to even more credit contraction.

So far US regulators have managed to buy into the risk of a rapid systemic banking crisis, the threat of which increased significantly in March. The situation with deposit outflows and the volume of emergency bank borrowings from the Fed has largely stabilised.

Nevertheless, the credit tightening process is already underway and at the systemic level the problems that appeared in March have not been resolved: the substantial amount of uninsured deposits, relatively unattractive (in comparison with e.g. government bond yields) deposit rates, unrealised bond losses due to rising market yields. The rapid shift from very low to high interest rates and tightening lending conditions may also lead to realisation of credit risks, i.e. growth of bad loans on banks’ balance sheets. Small and medium-sized regional banks and related segments of the real sector – for example, the commercial property market – remain the most vulnerable.

“So far, the threat of a major banking crisis in the US does not seem to be very high, but if it materialises and is not stopped quickly by regulators, it could lead not only to a tangible recession in the US, but also to “contagion” of the financial sector in other countries, funding squeezes, increased defaults, reduced demand and commodity prices.

About the author