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Investors, executives and economists are preparing contingency plans given the turmoil that could result from a U.S. Treasury default in a $24 trillion market.
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The US debt limit has been reached and the Treasury Department isfind ways to save money. Once the maneuvers are exhausted, what previously seemed inconceivable may become a reality: the default of the United States.
What happens then?
The long-term effects are difficult to predict: from shocks in financial markets to bankruptcies, recession and potentially irreparable damage to the nation's long-term role at the center of the global economy.
Probability of default remains low, at least based on assurances from opposing legislators that agreement will be reached on increasing or suspendingdebt limitand great opportunities from trading in certain financial markets. But as the day approaches when the US is running out of cash to pay the bills - what could it bealready June 1— investors, executives and economists around the world are imagining what could happen in the immediate before, during and after, making contingency plans and pondering largely untested policies and procedures.
"We're in uncharted waters," said Andy Sparks, head of portfolio management research at MSCI, which creates indices that track a wide range of financial assets, including the treasury bond market.
On the brink of insolvency, a "terror scenario" emerges.
Some corners of the financial marketsalready started shakingbut these ripples pale in comparison to the tidal wave that forms as the pattern approaches. The $24 trillion US Treasury market is the government's primary source of funding as well as the largest debt market in the world.
The treasury market is the backbone of the financial system, it is central to everything from mortgage rates to the dollar, the world's most used currency. Treasury debt is sometimes even treated as a cash equivalent due to government guarantees of creditworthiness.
The destruction of trust in such a deeply entrenched market would have consequences that are difficult to estimate. Most agree, however, that a default would be "catastrophic," said Calvin Norris, portfolio manager and interest rate strategist at Aegon Asset Management. "It would be a horror scenario."
A missed payment triggers a trading frenzy as markets begin to collapse.
The government pays its debts through banks that are members of the federal payment system called Fedwire. These payments then flow through the market pipeline, 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 repayment date for investors, it must notify Fedwire the day before the due date so investors know that the government was close to default the night before.
According to analysts at TD Securities, there is more than $1 trillion in Treasury debt maturing between May 31 and the end of June that could be refinanced to avoid default. There is also $13.6 billion in interest to be paid, spread over 11 terms; that equates to 11 different occasions for the government to miss a payment over the next month.
Fedwire, the payment system, closes at 4:30 p.m. If the due payment is not made by then at the latest, the markets will begin to collapse.
Stocks, corporate debt and the value of the dollar are likely to fall sharply. Volatility can be extreme, not just in the US, but around the world. In 2011, when lawmakers made a last-minute deal to avoid going over the debt limit, the S&P 500 fell 17% in just over two weeks. The post-default reaction may be more severe.
Perhaps counterintuitively, some Treasury bonds would be in high demand. Investors would likely get rid of any debts that are nearing maturity - for example, some money market funds have already shifted their portfolios away from June-due government bonds - and buy other future-maturing governments while still viewing them as a safe haven. stress.
The cascade of downgrades is driving bondholders "mad".
Joydeep Mukherji, principal credit ratings analyst for the United States at S&P Global Ratings, said an unpaid payment would cause the government to be declared "selective default" whereby it chose to forego some payments but is expected to continue to pay other debts. Fitch ratingshe said toowould downgrade the government's rating in a similar way. Such ratings are usually given to distressed companies and government borrowers.
Moody's, another major rating agency, said if the Treasury defaulted on one of its interest payments, its credit rating would be downgraded one notch to just below its current maximum rating. A second failure to pay interest would result in another reduction.
Moody's noted that a range of government-linked issuers would also likely be affected by a rating downgrade, from the agencies that underpin the mortgage market to hospitals, government contractors, railroads, utilities and defense firms dependent on government funding. This would also include foreign governments with guarantees for their own US debt, such as Israel.
Some fund managers are particularly sensitive to rating downgrades and may be forced to sell their Treasury holdings to comply with the minimum debt rating they can maintain, driving down their prices.
“I would be afraid that in addition to first-order madness, there will also be second-order madness: for example, if two of the top three rating agencies downgrade something, then you have a bunch of financial institutions that can't hold those bonds. said Austan Goolsbee, president of the Federal Reserve Bank of Chicago, at an event in Florida on Tuesday night.
The hydraulics of the financial system break down, making trading more expensive and more difficult.
Importantly, the default of one government bill, promissory note or bond does not trigger the default of all government debt, known as "cross-default," according to the Securities and Financial Markets Association industry group. This means that most of the government debt will remain outstanding.
This should limit the impact on markets that rely on Treasury debt as collateral, such as trillions of dollars in derivative contracts and short-term repurchase loans.
Even so, any collateral affected by the default would have to be replaced. CME Group, a major derivatives clearing house, said that while there are no plans to do so, it may prohibit the use of short-term government bonds as collateral or apply discounts to the value of certain assets used to hedge trades.
There is a risk that the pipes of the financial system will simply freeze as investors rush to reposition their portfolios while the big facilitating banks pull out of the market, making it difficult to buy and sell virtually any asset.
In the midst of this turmoil in the post-insolvency days, some investors may find themselves in a big windfall. After a three-day grace period, around $12 billion worth of credit default swaps can be triggered, a type of protection against bond defaults. The payment decision is made by aindustry committeethis includes large banks and fund managers.
The nation's global financial reputation is permanently weakened.
Once the panic subsides, confidence in the nation's central role in the global economy can be permanently altered.
Foreign investors and governments hold $7.6 trillion, or 31% of all Treasury debt, making them essential to the favorable financing conditions that the US government has long enjoyed.
However, after a default, the perceived risk of holding Treasury debt may increase, making it more expensive for the government to borrow in the foreseeable future. The pivotal role of the dollar in global trade may also be undermined.
Higher government borrowing costs would also make it more expensive for businesses to issue bonds and borrow money, and raise interest rates for consumers who take out mortgages or use credit cards.
Economically according toWhite House Projectionseven a brief default would result in the loss of half a million jobs and a somewhat shallow recession. A prolonged default would lead these figures to a catastrophic loss of eight million jobs and a major recession, with the economy shrinking by more than 6%.
These potential costs - wholly unknown but widely thought to be huge - are what many believe will motivate lawmakers to reach an agreement on the debt limit. "Every leader in the room understands the consequences if we don't pay our bills," President Biden said in a speech Wednesday as negotiations between Democrats and Republicansintensified. "The nation has never paid its debts and never will," he added.
Joe Rennison covers the financial markets and trading, from chronicling the whims of the stock market to explaining the often-mysterious trading decisions of Wall Streeters. @JArennison
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