For the first time in its history, the US has come close to defaulting. The count goes on for weeks. In as little as a month America could stop paying its bills. The White House has started active talks with the “financial hawks”, but there are no signs of a way out of the impasse yet.
The financial market, which has so far perceived the government debt problem as a “political spectacle” in an election year, has become nervous. Insurance premiums on 5-year bonds are at multi-year highs. Are the risks really that high?
Deadlock?
The US reached the debt ceiling of $31.4 trillion much earlier than economists expected – in January. Until now the issue of the borrowing limit has been discussed only politically, the markets have hardly paid any attention to this problem. The main question – what concessions will Democrats agree to in order to persuade Republicans to raise the bar again? – implied that the long wrangling would end in a happy ending. So far, however, the two parties in control of Congress have been unable to agree. “The reds link the debt issue with budget cuts. “The blue party considers the proposed programme unacceptable and insists on an unconditional extension of the debt limits.
While opponents argue, the “emergency measures” taken by the US Treasury, which include both accounting manoeuvres and a freeze on investments, are running out. Last week, the Treasury warned that it may have to stop borrowing altogether and rely solely on tax revenues to pay its bills. If Parliament does not increase the public debt limit by June 1, the Ministry of Finance will not be able to service its obligations in full. And if the Finance Ministry runs out of money, a default will occur. The Bipartisan Policy Center estimates that a default on U.S. debt could occur as soon as this summer – between early June and early August.
The president’s administration is looking for a way to get more time to negotiate with Republicans. One option to delay Date X is to persuade Congress to extend the budget lending at least until 30 September, when the fiscal year ends. Alternatively, to buy time, the White House could raise the borrowing limit short-term without congressional approval. US President Joe Biden can use the 14th amendment of the constitution to bypass Congress. Section four of the amendment states that the sustainability of US government debt must not be called into question.
Using the amendment to avoid default could lead to a constitutional crisis, US Treasury Secretary Janet Yellen has warned.
“We should not find ourselves in a situation where we have to contemplate whether the president can address the debt issue. That would be a constitutional crisis,” Yellen said when asked by an ABC News reporter about the implications of the 14th amendment of the constitution.
The US president discussed the situation around the national debt with congressional leaders at a meeting on Tuesday. It did not yield any significant results. At the end of the talks Biden only stated his readiness to discuss the budget “but not under the threat of default”. He also added that a possible default would be devastating for the US economy. On Friday, representatives from both houses of parliament will meet again with the president in the Oval Office to continue looking for a way out of the “debt impasse”. The positions remain unchanged so far, unlike the Treasury accounts, which are emptying before our eyes. And this is beginning to make the markets nervous. The account has gone into weeks.
‘Financial hawks’ make markets nervous
A default in the US would have “unprecedented” consequences for the economy, representatives of the borrowing advisory council (TBAC) have warned. The economists warn that an extended default could lead the American economy into a deep recession with soaring unemployment and destabilize the global financial system built on American bonds.
Although such a scenario is hard to believe, the protracted confrontation between the reds and blues raises the likelihood of its realisation.
At the moment, default is the biggest risk, bigger than a rate hike and US recession, says Natalia Malykh, head of equity analysis at Finam Group. Moreover, this risk is barely reflected in prices. Therefore, the closer the default approaches, the worse it will be for the market – investors will be more active in putting it into quotes. The expert believes that this could also trigger the collapse of new medium or small banks, as Americans may prefer to withdraw money from deposits, as usually happens during liquidity crises.
“In the event of a default, the whole equity market, even the highest quality and most promising cases, will sag because of the liquidity factor. I don’t think it will be possible to find a fully defensive asset, as even gold and silver fell substantially in 2008 before breaking records. The best strategy might be to go into cash, at least partially, to buy cheaper assets later,” comments Natalia Malykh.
On the other hand, says the analyst, if the debt ceiling does get raised by printing money, we could see a moderate rally by closing short positions, which have already exceeded market levels in autumn 2015, if we look at CFTC data on net speculative positions in S&P 500 futures.
“It is difficult to assess the potential damage right now. In any case, they will not stop servicing all liabilities, the default will be selective and likely spread across a number of items. It is unlikely to affect contracts with the military-industrial complex amid problems with Russia and China, as well as energy transition programmes, which both parties see as a long-term growth point for the economy. I think the social sector – healthcare, pensions, schools – will be affected by the cuts,” the expert commented.
One indicator of default is the cost of credit default swaps (CDS). Since February, the cost of the US bond contract has been at multi-year highs. The price of 5-year CDS has risen by 115% in six months and by 305% in a year. As of 10 May the value of this derivative stands at 65.29 points. In other words, the market assesses the probability of default as very high. The fact is that in a liquidity crunch, the US Treasury will firstly extinguish the shortest issues, placing the longest ones at the end of the queue.
According to US Treasury Department statistics, the largest holders of US debt securities (US treasuries) are Japan ($1.1 trillion) and China ($859.35 billion).
In January 2023, Russia invested $67 million in US government debt, of which $13 million was invested in short-term government bonds and $54 million in long-term bonds. In December 2022, investments in U.S. government debt amounted to $629 million.
If the U.S. is unable to pay its debts, the credibility of U.S. bonds will be undermined. This will lead to a sharp rise in the cost of borrowing and a fall in financial markets. Then the crisis will spread to the real sector. For the commodity economies this will translate into weakening national currencies, rising inflation, and a deep decline in production.
However, as long as the US dollar is the world’s reserve currency, there are no objective reasons for the issuer of this currency to default. Almost certainly the “financial hawks” will reach an agreement with the US president and the problem – once again – will be solved. For example, economists of the same TBAC suggest abolishing the borrowing limit altogether. And while the debate is raging, there is increased volatility on the financial markets.
