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Investors, executives and economists are preparing contingency plans as they consider the turmoil that would result from a default in the $24 trillion U.S. Treasury market.
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By Joe Rennison
The U.S. debt limit has been reached and the Treasury Department is finding ways to save cash. After it runs out of maneuvers, what once seemed unfathomable could become reality: The United States defaults.
What happens next?
The far-reaching effects are hard to fully predict: from shock waves in financial markets to bankruptcies, recession and potentially irreversible damage to the nation’s long-held role at the center of the global economy.
The probability of a default remains low, at least based on opposing lawmakers’ assurances that a deal will be done to raise or suspend the debt limit and the long odds implied by trading in certain financial markets. But as the day approaches when the United States begins to run out of cash to pay its bills — which could be as soon as June 1 — investors, executives and economists around the world are gaming out what might happen immediately before, during and after, hatching contingency plans and puzzling over largely untested rules and procedures.
“We are sailing into uncharted waters,” said Andy Sparks, head of portfolio management research at MSCI, which creates indexes that track a wide range of financial assets, including in the Treasury market.
On the cusp of default, a ‘horror scenario’ comes into view.
Some corners of the financial markets have already begun to shudder, but those ripples pale in comparison to the tidal wave that builds as a default approaches. The $24 trillion U.S. Treasury market is the primary source of financing for the government as well as the largest debt market in the world.
The Treasury market is the backbone of the financial system, integral to everything from mortgage rates to the dollar, the most widely used currency in the world. At times, Treasury debt is even treated as the equivalent of cash because of the surety of the government’s creditworthiness.
Shattering confidence in such a deeply embedded market would have effects that are hard to quantify. Most agree, however, that a default would be “catastrophic,” said Calvin Norris, a portfolio manager and interest rate strategist at Aegon Asset Management. “That would be a horror scenario.”
A missed payment sets off a trading frenzy as markets begin to unravel.
The government pays its debts via banks that are members of a federal payments system called Fedwire. These payments then flow through the market’s plumbing, eventually ending up in the accounts of debt holders, including individual savers, pension funds, insurance companies and central banks.
If the Treasury Department wants to change the date it repays investors, it would need to notify Fedwire the day before a payment is due, so investors would know the government was about to default the night before it happened.
There is more than $1 trillion of Treasury debt maturing between May 31 and the end of June that could be refinanced to avoid default, according to analysts at TD Securities. There are also $13.6 billion in interest payments due, spread out over 11 dates; that means 11 different opportunities for the government to miss a payment over the course of next month.
Fedwire, the payment system, closes at 4:30 p.m. If a payment due is not made by this time, at the very latest, the markets would begin to unravel.
Stocks, corporate debt and the value of the dollar would probably plummet. Volatility could be extreme, not just in the United States but across the world. In 2011, around when lawmakers struck a last-minute deal to avoid breaching the debt limit, the S&P 500 fell 17 percent in just over two weeks. The reaction after a default could be more severe.
Perhaps counterintuitively, some Treasury bonds would be in high demand. Investors would likely dump any debt with a payment coming due soon — for example, some money market funds have already shifted their holdings away from Treasuries that mature in June — and buy other Treasury securities with payments due further in the future, still seeing them as a haven in a period of stress.
A cascade of ratings downgrades creates ‘craziness’ for bondholders.
Joydeep Mukherji, the primary credit rating analyst for the United States at S&P Global Ratings, said that a missed payment would result in the government being considered in “selective default,” by which it has chosen to renege on some payments but is expected to keep paying other debts. Fitch Ratings has also said it would slash the government’s rating in a similar way. Such ratings are usually assigned to imperiled companies and government borrowers.
Moody’s, the other major rating agency, has said that if the Treasury misses one interest payment, its credit rating would be lowered by a notch, to just below its current top rating. A second missed interest payment would result in another downgrade.
A slew of government-linked issuers would also likely suffer downgrades, Moody’s noted, from the agencies that underpin the mortgage market to hospitals, government contractors, railroads, power utilities and defense companies reliant on government funds. It would also include foreign governments with guarantees on their own debt from the United States, such as Israel.
Some fund managers are particularly sensitive to ratings downgrades, and may be forced to sell their Treasury holdings to meet rules on the minimum ratings of the debt they are allowed to hold, depressing their prices.
“I would fear, besides the first-order craziness, there’s second-order craziness too: Like, if you get two of the three of the major rating agencies downgrade something, then you have a bunch of financial institutions that can’t hold those securities,” Austan Goolsbee, president of the Federal Reserve Bank of Chicago, said at an event in Florida on Tuesday night.
The financial system’s plumbing freezes up, making trading more costly and difficult.
Importantly, a default on one government bill, note or bond does not trigger a default across all of the government’s debt, known as “cross default,” according to the Securities Industry and Financial Markets Association, an industry group. This means that a majority of the government’s debt would remain current.
That should limit the effect on markets that rely on Treasury debt for collateral, such as trillions of dollars worth of derivatives contracts and short-term loans called repurchase agreements.
Still, any collateral affected by a default would need to be replaced. CME Group, a large derivatives clearing house, has said that while it has no plans to do so, it could prohibit short-dated Treasuries from being used as collateral, or apply discounts to the value of some assets used to secure transactions.
There is a risk that the financial system’s pipes simply freeze over, as investors rush to reposition their portfolios while big banks that facilitate trading step back from the market, making buying and selling just about any asset more difficult.
Amid this tumult in the days after a default, a few investors could be in for a major windfall. After a three-day grace period, some $12 billion of credit default swaps, a type of protection against a bond default, may be triggered. The decision on payouts is made by an industry committee that includes big banks and fund managers.
The nation’s global financial reputation is permanently diminished.
As panic subsides, confidence in the nation’s fundamental role in the global economy may be permanently altered.
Foreign investors and governments hold $7.6 trillion, or 31 percent, of all Treasury debt, making them vital to the favorable financing conditions that the U.S. government has long enjoyed.
But after a default, the perceived risk of holding Treasury debt could rise, making it more costly for the government to borrow for the foreseeable future. The dollar’s central role in world trade may also be undermined.
Higher government borrowing costs would also make it more expensive for companies to issue bonds and take out loans, as well as raise interest rates for consumers taking out mortgages or using credit cards.
Economically, according to forecasts by the White House even a brief default would result in half a million lost jobs and a somewhat shallow recession. A protracted default would push those numbers to a devastating eight million lost jobs and a severe recession, with the economy shrinking by more than 6 percent.
These potential costs — unknowable in total but widely thought to be enormous — are what many believe will motivate lawmakers to reach a deal on the debt limit. “Every leader in the room understands the consequences if we fail to pay our bills,” President Biden said in a speech on Wednesday, as negotiations between Democrats and Republicans intensified. “The nation has never defaulted on its debt, and it never will,” he added.
Joe Rennison covers financial markets and trading, a beat that ranges from chronicling the vagaries of the stock market to explaining the often-inscrutable trading decisions of Wall Street insiders. @JARennison
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What Would Happen if the U.S. Defaulted on Its Debt? ›
It would be an unfettered economic catastrophe. Our model indicates that unemployment would surge above 12% in the first six months, the economy would contract by more than 10%, triggering a deep and lasting recession, and inflation would soar toward 11% over the next year.What would happen if the US defaults on debt? ›
U.S. debt, long viewed as ultra-safe
Its debt, long viewed as an ultra-safe asset, is a foundation of global commerce, built on decades of trust in the United States. A default could shatter the $24 trillion market for Treasury debt, cause financial markets to freeze up and ignite an international crisis.
Defaulting on any payment will reduce your credit score, impair your ability to borrow money in the future, lead to fees, and possibly result in the seizure of your personal property.Who does the US owe money to? ›
However, this has declined over time, and as of 2022 they controlled approximately 25% of foreign-owned debt. As of January 2023, the five countries owning the most US debt are Japan ($1.1 trillion), China ($859 billion), the United Kingdom ($668 billion), Belgium ($331 billion), and Luxembourg ($318 billion).What country has no debt? ›
|Characteristic||National debt in relation to GDP|
|Hong Kong SAR||4.26%|
A US debt default could spark a 45% crash in the stock market and generate a deep recession akin to the 2008 Great Financial Crisis, the White House's Council of Economic Advisers warned earlier this month.What is the probability of the US debt default? ›
A debt default is not likely to happen. Even under the current gridlocked circumstances, Moody's Analytics puts the chances of a default happening at 10%.How long can a default last? ›
A default will stay on your credit file for six years from the date of default, regardless of whether you pay off the debt. But the good news is that once your default is removed, the lender won't be able to re-register it, even if you still owe them money.Do any countries owe America money? ›
Top Foreign Holders of U.S. Debt
With $1.1 trillion in Treasury holdings, Japan is the largest foreign holder of U.S. debt. Japan surpassed China as the top holder in 2019 as China shed over $250 billion, or 30% of its holdings in four years.
The Federal Reserve, which purchases and sells Treasury securities as a means to influence federal interest rates and the nation's money supply, is the largest holder of such debt.
Does China have more debt than the US? ›
The United States, holding the highest national debt globally, has a total of $31.68 trillion, representing a YoY increase of $1.3 trillion or 4.28%, reaching $30.38 trillion. Therefore, China's national debt has surged almost three times that of the United States in the past 12 months.What country is #1 in debt? ›
United States. The United States boasts both the world's biggest national debt in terms of dollar amount and its largest economy, which resolves to a debt-to GDP ratio of approximately 128.13%. The United States' government's spending exceeds its income most years, and the US has not had a budget surplus since 2001.Why is the US in so much debt? ›
The federal government needs to borrow money to pay its bills when its ongoing spending activities and investments cannot be funded by federal revenues alone. Decreases in federal revenue are largely due to either a decrease in tax rates or individuals or corporations making less money.How much is China's debt? ›
International Monetary Fund data show China's explicit local government debt nearly doubled over five years to the equivalent of $5.14 trillion — or 35.34 trillion yuan — last year.What does it mean when you get a default? ›
Default is the failure to repay a loan according to the terms agreed to in the promissory note.Should I pay off a default? ›
Technically, paying a default won't have a direct impact or improve your credit score. Over time, however, your score will gradually improve as the default gets older. Plus, some lenders will only lend once the defaults are cleared. Therefore, paying the default as quickly as possible is in your best interest.Can you come out of default? ›
Involuntary payments may continue to be taken until your loan is no longer in default or until you have made some of your rehabilitation payments. Once you have made the required nine payments, your loans will no longer be in default.How long does it take to recover from a default? ›
A default will stay on your credit reports for up to seven years, and prospective lenders will be far more reluctant to extend credit to you. You should make an effort to repay the defaulted loan or credit card debt whenever possible.