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Time is pressing: the biggest risk for the market is that the US defaults on its debt

Date: February 28, 2024 Time: 20:01:35

Tick, tock… The hands of the clock are moving forward irremediably and there is no time to lose in terms of US fiscal policy. Democrats and Republicans are in full negotiations to extend the debt ceiling. An agreement that is fundamental for the whole world since, if the debt is not paid (default) it would mean, in the words of Janet Yellen, Secretary of the Treasury of the North American country, “an economic disaster”.

What is happening and how can it be channeled into the markets? The US federal government reached its debt limit of 31.4 trillion dollars on January 19, which led the Treasury to adopt a series of extraordinary measures, such as the postponement of investments in federal pensions.

Since then Joe Biden, President of the United States, and Kevin McCarthy, leader of the Republicans in Congress, have held back-and-forth negotiations: while the former has always positioned himself to raise the ceiling first and negotiate the ins and outs of the adjustments of spending afterwards, the second has opted at another time for closing a series of definitions in the first instance and putting a new limit on indebtedness afterwards. The chicken and the egg or the chicken and the egg. Nobody has given up.

In the latest talks it seems that both Biden and McCarthy are a little closer, but many experts believe that the positions are going to be quite acrimonious until the deadline is reached. And meanwhile, the markets are discounting the risk progressively. The CDS (default insurance) of the US debt, a kind of insurance against possible default, have exceeded the level of 150, a level that had not been reached since the financial crisis of 2008.

The question is what is the scheme that the investor has to face in this environment. “Our baseline scenario is that the federal government raises or lifts the debt ceiling at the last moment, after reaching an agreement on some type of spending reduction program,” according to Dennis Shen, a sovereign debt analyst at Scope Ratings.

However, the risk surrounding this debt ceiling crisis is the highest it has been in ten years, and the risks to ratings are more pronounced than ever, at a time of heightened political polarization and higher deficits following the recent crisis economy. “Substantial spending obligations limit the time and space available to the government to resolve the debt ceiling crisis, so we estimate the US general government deficit at a significant 5.4% of GDP this year,” it adds. Shen.

The main risks

What risks are involved for the global economy if the United States cannot raise the national debt ceiling? As April’s political economist Lizzy Galbraith discusses, debt ceiling tensions are already having economic consequences. “The market is responding to the risks by locking up debt due in June, July and August, and raising the price of one-year Credit Default Swaps (CDS) to all-time highs,” she recalls.

But the possible negative catalyst for the markets could come from the credit rating agencies. “A downgrade of the United States’ credit rating is possible, even if an agreement is reached, as happened in 2011,” highlights the British manager’s expert on the current situation.

If the deadline is missed, an unlikely but possible scenario, the government would be forced to significantly cut spending, possibly cutting or ending pension and benefit payments, affecting Americans’ incomes. In the opinion of François Raynaud, a multi-asset & overlay fund manager at Edmond de Rothschild AM, if the US is unable to raise it, that will mean the Treasury will resort to “extraordinary spending restraint measures” in the first place.

“The real risk is linked to the inability to find a compromise between Republicans and Democrats, which could mean a short or long default. Although this is a remote risk that has never occurred, the risk is probably higher today due to the current political climate in the United States,” he comments.

Estimates of the White House economic effects in the third quarter of 2023 range from -0.3% to -6.1% annualized US real GDP growth. “Taking into account that the United States represents 15% of world GDP, the impact could go up to -0.9% in the most serious scenario, although the most unlikely one”, asserts the EdRAM expert.

It should be remembered that the United States has already stopped paying the federal debt on time on other occasions. The most recent example of a technical default occurred in 1979, due in part to partisan abuse of the debt ceiling. Markets should not automatically assume that debt ceiling disputes are inevitably resolved in the blink of an eye.

In this sense, history can be a useful guide and comparisons have been made with similar events in 2011, when the debt ceiling was raised for only two days. The market reaction was tied to a severe loss of confidence, with US Treasuries rallying despite losing their AAA rating, safe haven currencies outperforming and credit spreads widening.

However, one must be careful when making direct comparisons with this period: the market environment was very different then. “At the same time, the eurozone faced its own challenges and peripheral country bond spreads struggled to widen, which did not result in weakness in other cyclical assets,” says Paul Grainger, head of global fixed income and currencies. from Schröders.

“This time, we are approaching the end of the most aggressive rate hike cycles in the last 40 years and interest rates are already much higher and, on top of that, we also have the headwind of tightening for growth. of credit conditions”, concludes Grainger, making it clear that each historical moment has its particularities. We are close to the outcome.

* This website provides news content gathered from various internet sources. It is crucial to understand that we are not responsible for the accuracy, completeness, or reliability of the information presented Read More

Puck Henry
Puck Henry
Puck Henry is an editor for ePrimefeed covering all types of news.
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