What the markets are saying about the risk of debt default (2023)

Headlines have warned for weeks of a possible debt default by the US. The negotiations have become contentious, with a deadline that could come as early as June 1.

Because Treasuries are the linchpin of the global financial system, the "risk-free" asset on which everything else is built, the consequences of a US debt default would be dire, perhaps truly catastrophic.

But how likely is it that any of this will actually happen?

President Biden and President Kevin McCarthy say they understand a default would be a disaster, but negotiations stalled Friday and until legislation to raise the debt ceiling is passed, the outcome is uncertain. And the markets weigh the odds carefully.

In short, they predict that a default is most likely to occur.nohappen, but they nevertheless suggest that a disaster is still very possible and that the odds adjust quickly as the news changes. If a final solution is not reached soon, the relative calm that has prevailed in the markets could quickly unravel.

I pointed out last week that insurance costs by an American standard have skyrocketed. As the deadlock over the debt ceiling threatens, the US is seen in30 billion dollars the credit default swap marketas a riskier borrower than countries such as Bulgaria, Croatia, Greece, Mexico and the Philippines. Compared to Germany, the cost of insuring US debt is about 50 times higher.

But as several readers have pointed out, I didn't say what the numbers tell us about how risky US bonds have become. This is not a trivial matter. So here's a closer look.

What is at stake

As politicians in Washington talk about the possibility of the government breaching the debt ceiling, preparations are being made on Wall Street and in US government agencies for a wide range of worrying contingencies.

Even enumeration ofpossible effectsof a fracture is worrying. They can range from a controllable event, consisting of a late payment on a specific Treasury bill affecting a fairly small number of creditors, to something far more catastrophic: the suspension of all Social Security checks and debt payments by the U.S. government, accompanied by a sudden collapse of world markets and a recession.

As former finance minister Jacob Lewsayinglast month at a meeting of the Council on Foreign Relations, "I think it's pretty safe to say that if we were to default, the chances of a recession are almost certain."

What Treasury rates tell us

The price of short-term Treasuries reveals that traders believe there is a fair chance the U.S. Treasury will stop paying interest or principal on securities maturing in early June. Is whenTreasury Secretary Janet L. Yellensays the US is likely to exhaust all "extraordinary measures" that have kept government borrowing below the debt ceiling.

Concern about what might happen in the first few days of June is the main reason for an irregularity in the interest rates on Treasury bills. Money market fund managers, nervous about a possible default, have avoided Treasuries maturing, cutting prices and raising yields to a level 0.6 percentage points higher than Treasuries maturing in July. In August and September, it is assumed that some degree of normality will have returned and factors such as inflation and Fed interest rate policy will regain their usual dominance. The yield on bills maturing later in the summer and early fall is higher than in July. This bar pattern is unusual.

This implies two things. First, the markets believe there isesa real risk of default in early June. Second, the possibility of along lastingThe US default on its bills is considered extremely low.

That's because the problem is fundamentally political, not economic.

The markets will supply the US government with all the money it needs if only Congress gives the green light to borrow it. The Treasury market is the deepest and most liquid market in the world. Demand for Treasuries is strong and likely to remain so as long as US credit is not affected.

But a U.S. debt default could change all that, and another downgrade of U.S. debt, as happened in 2011 when the U.S. came close to default, could raise U.S. borrowing costs

Behind the dispute is a fundamental reality: the country spends far more money than it brings in on taxes and other income. To pay off its debt, the government must borrow regularly by issuing large amounts of government bonds. This implies an increase in the level of debt.

It's a touchy subject for many people, including former President Donald J. Trump, who ran large deficits during his own presidency but now advocates deep spending cuts.

Republicans should insist on trillions of dollars in cuts now, Mr. Trumpsayinglast week during a live town hall hosted by CNN. If the White House disagrees, he said, "you're going to have to default."

Sr. BidenHe has said that long-term fiscal policy issues should be dealt with separately from the debt ceiling, which is a mere formality. McCarthy spokesmaninsiststhat a final agreement must contain long-term expenditure cuts.

Most economists say that when borrowed money is used productively and borrowed at a reasonable interest rate, deficits need not be a problem. Details matter. But paying off America's debt on time is critical to the proper functioning of financial markets.

What Credit Default Swaps Say

At the moment, the stock market and the bond market generally treat the debt ceiling negotiations as nothing. Other problems predominate: persistentinflation, altRenter,bank crashthe possibility of an impendingrecessionand of a focal point atFederal Reserve, after tightening economic conditions for more than a year.

The debt ceiling impasse in the summer of 2011 was different. Then the shares fell sharply.

There has been no similar stock market action so far, and this may be partly because the credit default swap market sees the current situation as less risky than the 2011 crisis.

Credit default swaps are a form of insurance. When the prices or "spreads" on these securities increase, they reflect the market's perception that the underlying bonds, in this case government bonds, have become riskier. These spreads can be used to derive accurate predictions about a default,

At its worst in 2011, the swap price implied a 6.9% probability of US debt default, according toandy gnister, managing director and head of portfolio management research atMSCI, the financial company. The swap market's most ominous prediction this year came around May 11, when Trump made his remarks. The probability of default then reached 4.2 percent. Before the news of headwinds in trading on Friday, it hovered around 3.6 per cent.

That's a big increase from January, when the probability of default was close to zero. But even though swap spreads are now much wider for Treasuries than they were in 2011, savvy market participants know that when calculating implied default probabilities, another important factor also counts: the price of the underlying bonds.

This is often misunderstood, as Mr. Sparks explained. "It's important to realize that the spread is only part of the probability calculation," he said.

It's strange, but important: Due to rising inflation and rising interest rates, bond prices moving in the opposite direction are much lower than comparable duration bonds in 2011. With prices lower At today's lows, the probability of default is lower than it was in 2011 , although swap spreads are wider.

In short, the credit default swap market is saying that investors should worry about a default, but they probably don't need to worry too much, at least not yet.

Forecasting a prediction market

A simpler and smaller market has resulted in a higher probability of default of around 10 percent. This iskalshithe prediction marketTarek Mansour, one of Kalshi's founders, told me that his market reflected "the view of Main Street, not just Wall Street, which is all you get from the credit swap market."

Kalshi asks a simple question: Will the US default on its debt by the end of the calendar year? For a small fee, anyone can play on this "event contract". Kalshi has a good track record in predicting inflation and interest rates and I find his data interesting but not the final word.

What is the real probability of US debt default? Given recent history, I would simply say that while the chance of a major disaster is quite small, it is high enough to prepare for.

I keep a lot of cash in safe places in case there is a power outage, but I'm investing for the long term. Definitely don't panic if the stock market falls sharply. It could even be a buying opportunity because stocks have always risen on previous debt ceiling fears.

With any luck, there will be an agreement in Washington and these concerns will be mooted. Let us hope that there is no need for a new chapter in the history of political dysfunction.