The US government is weeks away from running out of cash, officials have warned, raising the possibility it will default on its bonds if a political fight in Washington over the debt ceiling is not resolved.
Analysts, economists and industry groups expect the White House and Congress will, as has happened so many times previously, strike a deal and stave off a default. But treasury secretary Janet Yellen has warned that, if they do not, then the US may be unable to pay its bills as soon as June 1st, a view backed by the Congressional Budget Office, a non-partisan government agency.
What would a default look like?
The US would be in default if it did not make scheduled payments to investors holding government debt, known as treasuries. Among big holders are foreign central banks, which depend on treasuries and US dollars for their monetary reserves.
The US’s credit rating would then be downgraded. Missing other payments – such as social security and Medicare disbursements or government and military salaries – would not constitute a default, according to Moody’s and S&P.
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Some Republicans in Congress have discussed the possibility of the treasury prioritising bond payments if a default is close. But Yellen has rebuffed that idea and called making debt payments but delaying others a “default by another name”.
Analysis from the White House suggests a short-lived default would result in half a million lost jobs and a 0.6 per cent decline in gross domestic product. A default that drags on for longer could lead to 8.3 million job losses and a 6.1 per cent decline in GDP. Borrowing costs in both scenarios would rise.
A default “would trash the credit score of the United States government. And it would take a long time to repair, just like it does with an individual”, said David Kelly, chief global strategist at JPMorgan. Because of that downgrade, “US taxpayers would have to pay far more in taxes for decades to come”.
What payments will the US have to make?
The US is responsible for making big interest and principal payments on bonds around the so-called X-date, the day when the government runs out of money.
Interest payments on treasuries are made on the 15th and the last day of each month. The end of month payment for May is expected to be between $10 billion (€9.2 billion) and $16 billion, according to estimates from the Congressional Budget Office. In June, the mid-month payment will be about $3 billion, while the end-of-month payment could be, again, between $10 billion and $16 billion.
Investors own roughly $90 billion in treasuries maturing at the end of May, and $138 billion maturing throughout June that the treasury is responsible for paying out, according to estimates from TD Securities.
Large payments for domestic commitments, such as healthcare and social security, are also due in the coming weeks.
The Congressional Budget Office estimates the treasury has about $360 billion available for May and early June, until additional quarterly tax payments come in on June 15th.
“The first couple weeks in June are going to be very dicey,” said William Hoagland, a vice-president at the Bipartisan Policy Center.
What would happen to markets if there is a default?
Riskier assets such as US stocks and corporate bonds would face large losses. US bonds and the dollar are traditionally haven assets for investors in volatile periods so, paradoxically, they may rise in value immediately after a default – even though the default would be on US debt. That is because investors say the willingness and ability of the US to pay its bondholders is ultimately not in question.
An outright US default is “unthinkable” as it would “wreak havoc” on global financial markets, said Seema Shah, chief global strategist at Principal Asset Management. Bank of America’s monthly fund manager survey shows 29 per cent of managers expect no resolution to the impasse, up from 20 per cent in April.
But for holders of insurance on US government bonds, the price of which has risen to record highs recently as default fears have grown, a potentially enormous payout awaits.
Credit default swaps are contracts between two market participants, one of whom agrees to make a payment if the issuer defaults on its debt. The size of that payment is in effect the difference between the original value of a bond and its current market value.
The bond used to determine that payout is typically the cheapest one on the market issued by the borrower. The difference in price between the cheapest bond on the market and the one for which the insurance was purchased is not always huge. But for a US default it is, because the steep rise in interest rates since early 2022 means there are treasury bonds in circulation that are trading at a large discount – below 60 cents on the dollar.
That could mean an enormous return for holders of CDS, provided that the US does not make a payment on its bonds within three days, the grace period allowed by the International Swaps and Derivatives Association.
For those buying protection via CDS, “if (they) get lucky and [Washington] DC screws up, (they) get to settle against this really cheap bond that wouldn’t normally exist except we’ve had this enormous increase in interest rates”, said Peter Tchir, head of macro strategy at Academy Securities. “The payout is going to be much higher than it has been in the past, because of interest rates.”
What can the Federal Reserve do?
Fed chairman Jay Powell has been adamant that the central bank is limited in its capacity to offset any damage triggered by a default, although officials have in the past outlined ways in which it could act.
For instance, in transcripts from deliberations in 2011 and 2013 – other years featuring debt stand-offs – the central bank discussed using regular tools such as removing securities from the market overnight and lending out cash through its repo operations, or even purchasing treasuries outright.
But that could mean the Fed has to halt its plan to reduce the size of its balance sheet.
Another alternative was for the Fed to remove defaulted treasury securities from circulation, either purchasing the affected notes or swapping those for others it owned. In 2013 Powell, then a governor, called the options “loathsome”, although he did admit that “under certain circumstances” he could potentially consider supporting such solutions. – Copyright The Financial Times Limited 2023
