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EVERYONE in the markets has known about the August 2nd debt ceiling deadline for a while but have tended to blithely assume that a deal will be done. Other crises, notably Europe's sovereign debt problems, have loomed larger in investors' minds. Only now, with a week to go before the deadline, are they starting to fret.
There is no sign of panic yet and investors are probably assuming three things. Option 1 is that a deal will be done at 11.59 on August 1st, even if it is only a stopgap. Option 2 is that August 2nd is not the hard-and-fast date it has been made out to be. Some analysts are suggesting that, since tax revenues have been higher than forecast, the government can pay its bills until August 10th, or even September. Option 3 is that the government puts workers on temporary lay-offs or stops payments to suppliers before it defaults on its debts.
But what if all those options failed? What would be the consequence of even a notional default? The IMF has talked of a global recession if there was a loss of confidence in US solvency although it's not clear that a failure to roll over debt for a few days would qualify for that description.
Having seen what happened with Lehman's default, the main worry would be a freeze in the markets. Take the finances of banks, for example. Many use Treasury bonds as the risk-free asset for capital purposes. As Capital Economics points out Government debt is only automatically 0% risk-weighted for banks under Basel II if it is rated AA- or higher (although regulators can make exceptions for domestic government debt issued in local currency). In principle, therefore, financial institutions would face significantly higher capital charges in the event of a US government default.
In practice, it seems likely that the regulators would move quickly to waive the rules. But there might be a few hairy moments while they did. And what about money-market funds? Having been burned by the credit crunch, many have opted for the safe haven of US Treasury bills. Perhaps they could roll over those bills into some form of IOU from the government. But if investors demanded their money back at a time when Treasury bills were illiquid, money-market funds might be forced to suspend resumptions or "break the buck". Then there is the repo market, widely used by financial institutions to raise money; Treasury securities are used as collateral for such borrowing.
Standard & Poor's has considered this scenario and suggests thatFailure to pay off maturing debt or missing interest payments (approximately $62 billion of interest is payable on Aug. 15) would constitute a selective default pursuant to our criteria, and Standard & Poor's expects it would lower the sovereign rating to 'SD'. Even if the Fed and other central banks managed to keep the financial system functioning, we expect that markets around the world would be severely damaged. In such a hypothetical scenario, we expect that equity markets would generally plunge, borrowing costs and interbank lending rates would soar, and corporate credit markets would be closed to all but the highest quality issuers. We envisage that consumers and businesses would likely stop spending on all but essential items, and the value of the dollar would drop by 10% or more against other major currencies. With the dollar heading lower, investors would likely look for hard assets like oil and other commodities, driving prices higher.
Given the fragility of the economic recovery, this is an incredible risk to contemplate. It is also worth noting that, even a freeze on government spending that stopped short of a default, would have a significant impact on demand.
Investors may be holding on to Treasury bonds because they have little option. The only other market that is liquid enough to absorb their cash is European government debt, and that has its own problems. The relative tranquility of the markets at the moment might, however, be the calm before the storm.
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