US Treasuries are considered the ultimate risk-free asset. It is the world’s most liquid financial instrument, the most widely used collateral in financial transactions and the cornerstone of US dollar reserve currency status.
A default by the US federal government could call these attributes into question and jeopardize the stability of the global financial system itself. We believe the risk of the Treasury Department defaulting on its debt is low, but the impact if it does occur is high. Declining consumption and investment and increasing financial shocks will undermine US and global growth and investor confidence.
Absent a technical default by the Treasury Department within months of the collapse of a US regional bank, prolonged debt ceiling negotiations could hurt investment sentiment. A technical default by the Treasury would be even worse. The prioritization of federal payments is accompanied by a contraction in real output, which would be significant if the government were to default on its debts.
If the U.S. Treasury were to default, the functioning of the U.S. Treasury market could be as impaired as it was in March 2020, or worse. At the time, the threat of the US economy shutting down put serious pressure on countries with low liquidity. Both government and private entities are rushing to sell off-the-run government bonds.
In the event of default, rating agencies may downgrade U.S. federal debt, as well as corporate debt that enjoys an explicit or implied backstop from the U.S. government. These include institutions such as large banking organizations and government-sponsored enterprises (GSEs), among others. Businesses and other private entities securing loans with the Treasury may be forced to look for alternatives, which will increase overall borrowing costs.
In addition, the money market, a de facto source of funding for financial institutions and other private sector institutions, could be seized as investors flee money market funds that hold only US government securities.Longer term, foreign holdings of U.S. Treasuries may decline, weighing on the U.S. dollar
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Washington’s political system makes debt ceiling negotiations very complicated. This year, the Republican Conservative caucus is asking for a commitment to cut federal spending as part of negotiations with the White House. Democrats say they had no problem agreeing to raise the debt ceiling under the previous administration, which was very unpopular with voters.
US House Speaker Kevin McCarthy is in a particularly difficult political position. He has already conceded to the right wing of his own party, allowing his one member of the House of Representatives to hold a no-confidence vote. If he moves toward a compromise with the White House and Democrats, he could lose a simple majority.On the other hand, no politician wants the legacy of a failed debt ceiling.
For context, we have effectively reached the actual debt ceiling of $31.4 trillion in January 2023. The event received little market reaction at the time because the Treasury still has two (temporary) instruments to fund federal spending: 1) Treasury General Account Cash (TGA) ) agreements with the Federal Reserve Board; and 2) so-called “special measures”.
Until recently, most analysts predicted that these would be exhausted by August 2023, with September being the tough deadline, but Yellen recently said it could be as early as June 1. warned that there is
Debt ceiling negotiations are also taking place against the United States’ increasingly unsustainable debt trajectory. The latest estimates from the Congressional Budget Office (CBO) show that federal debt held by the public sector will reach 118% of gross domestic product (GDP) by 2033 and the debt burden will reach $46 trillion by fiscal 2033. Suggested. Federal debt may increase. More than 130% of GDP if policy makers extend various expired policies. Moreover, these projections are based on an economic outlook without future crises with financial implications such as those experienced in 2008 or 2020.
US public debt has grown faster than the economy for more than 50 years. At the same time, they argue that interest rates have fallen more often than they have risen, and that public sector borrowing is not crowding out U.S. private investment.
Many analysts point to the dollar’s supreme status as a reserve currency and, relative to that, the most used currency in international trade, as the main reason for the lack of a “crowding out” effect. . However, it is important to note that investors’ liability concerns tend to manifest in a non-linear fashion.
In the short term, low equity volatility and tightening corporate credit spreads may still cloud the cautious investor sentiment. As we approach June, market volatility may increase and investor sentiment may deteriorate.
If so, the concern would reinforce an already cautious stance by the banking sector and allow a reduction in the supply of credit to the broader economy. The resulting credit crunch will likely be epicenter in US regional banks, increasing the risk of a recession starting later this year.
Sonia Meskin is Head of US Macro for BNY Mellon Investment Management. She previously held roles at the International Monetary Fund, Standard Chartered Bank, and the Federal Reserve Bank of New York.
more: The Debt Ceiling Confrontation: With the US likely to face a default on June 1st, the next steps are:
Also Read: What happens to Social Security payments if no debt ceiling agreement is reached?
