Thinking the unthinkable: what if the US defaults?
While the risk of the US government defaulting on its debt is relatively low, it is higher than it has been in the past. At the very least, investors should buckle up for a bruising battle over the debt ceiling that could inject market volatility and weigh on economic activity.
The US hit its statutory debt limit of $31.4 trillion on 19 January 2023. In response, the Treasury has resorted to accounting sleight-of-hand to ensure it can meet its obligations. But if the debt ceiling is neither raised nor suspended by a yet unknown ‘x-date’ later this year, these workarounds will be exhausted and the US will be unable to borrow more and will technically default on its debt.
It is far from the first time the country has stood on the precipice of default. In fact, the debt ceiling has been modified more than 100 times since the World War II. So why should this time be any different? After all, one of the few things that Democrats and Republicans both agree on is the importance of upholding the full faith and credit of the US government.
Each side will no doubt stick to the well-worn playbook of running down the clock to x-date in an effort to make the other blink first. Republicans are seeking deep spending cuts, whereas President Biden wants to raise taxes on corporates and high earners. If past is prologue, the two will engage in partisan brinkmanship until eventually settling on a last-minute compromise.
Such high stakes tactics always run the risk of backfiring as it could lead to an inadvertent default. And the likelihood of such an outcome is more elevated than it has been in previous years. Concessions made by the House Speaker limits the number of legislative solutions, while the ever-increasing political polarisation complicates the task of consensus building.
In this note, we explore how a US default could materialise and what it would mean for markets and the global economy.
Why a default can’t be ruled out
Congress has been left divided following the outcome of the midterm elections, but Republicans only have a narrow five-seat majority in the House of Representatives. Around 20 ultra-conservatives exploited this during Kevin McCarthy’s bid to be House Speaker, only permitting him to take the gavel on his 15th attempt after making a number of concessions.
Among them was reinstatement of the prior "motion to vacate" procedure. Now a single member can force a vote on whether to oust the House speaker, reversing the 2019 changes that had required a majority of either party to agree to it. As such, a minority of fiscal hawks will be able to hold the speaker’s feet to the fire in debt ceiling negotiations.
In its opening salvo, the Republican’s 45-strong Freedom Caucus has demanded that discretionary spending be capped at 2022 levels for the next 10 years. Such a hardline ideological position puts it on a collision course with the Democrats and their more moderate Republican colleagues. Unless some middle ground can be found, there is a risk the debt ceiling might not be raised.
There is limited scope for a workaround
If a US default looked to be on the cards, a handful of moderate Republicans might be motivated to defy their leadership and side with the Democrats in voting for a ‘clean’ increase to the debt ceiling. Besides the fact that this would just kick the can down the road, it would also come up against a number of legislative hurdles.
For one, the speaker has pledged to adhere to the Hastert Rule, which states a bill will only be brought to the floor “if the majority of the majority” supports it. Any rebellion might therefore need at least 112 Republicans. A possible workaround might be a discharge petition, which forces a bill to a vote on the House floor if a majority of the House signs it.
However, it is a slow and clumsy process. For one, the bill must have been sat in committee for 30 legislative days and then be on a House calendar for a further seven. But if the speaker and/or members of the House Rules Committee object to the bill, it would only be eligible for consideration on discharge days. These only occur twice a month when the House is in session.
If all else fails, unorthodox options might be considered. The Treasury could mint a $1 trillion platinum coin and deposit this at the Federal Reserve (Fed) for cash. Or the president could invoke the 14th amendment to unilaterally raise the debt ceiling. Either are a remote prospect, as undermining the legislative branch in such a way would likely unsettle investors.
A US default would be felt around the world
Assuming that x-date passes without the debt ceiling being raised, coupon payments and redemptions of Treasury securities will stop. Uncle Sam will be in default. While technical lapses have occurred, such as the 1979 check-processing glitch that delayed some redemption requests, a true default would be an unprecedented event with far-reaching ramifications.
In our latest Viewpoint, we set out a risk scenario in which US politicians start to openly talk about a default after a breakdown in talks. This results in a sell-off in Treasuries which then spreads to vulnerable debt markets, forcing governments to retrench around the world. The abrupt tightening of financial conditions being particularly bad news for emerging markets reliant on capital flows.
Economic activity is further dampened via other channels. Alongside the higher cost of financing debt, market volatility dents both consumer and corporate confidence, causing investment intentions to be scaled back and households to build up precautionary savings. In the US specifically, the government shutdown also hits federal spending and activity.
Central banks are spurred into action. The Fed stops quantitative tightening and cuts rates, with its peers in advanced economies following suit. However, policymakers in emerging markets are forced to keep policy rates elevated to defend their currencies, with some even having to enact aggressive hikes to stem capital outflows.
Eventually, Congress reaches an agreement to raise the debt ceiling. But the damage is done. Global growth is markedly slower; in this scenario, it is 0.7% below our baseline projections across 2023 and 2024 combined. If there is one silver lining, it is that weaker demand is assumed to make inflation some 0.5% lower relative to our central forecast across the same period.
Conclusion: hope for success, but plan for failure
While the threats of default will be used as leverage in debt ceiling negotiations, even the most fiscally conservative Republicans are unlikely to deliberately allow the US to default. It is effectively the hostage that can’t be shot. However, an ‘accidental’ default could come about if there were to be a miscalculation of the limits of brinkmanship and/or the duration of political processes.
Such a possibility is heightened by the uncertainty over when x-date will fall. The Congressional Budget Office estimates it will be sometime between July and September, but it could be earlier if annual tax returns filed in April disappoint versus expectations. Also, the lack of a kink in the Treasury curve suggests that investors remain reticent to take any bets on when it could be.
Even if a default is averted, markets could prove choppy. Back in 2011, investors were on edge as Congress spent months battling over the debt ceiling before raising it with just two days to spare. Not long after, the US was stripped of its top-notch AAA rating for the first time. The resulting risk-off move saw the US dollar depreciate, the S&P 500 sink and credit spreads widen.
Given the risk of a repeat crisis, investors ought to reflect on their portfolio positioning. Parking capital in T-Bills might be tempting given current yields, but these have historically come under pressure as the clock ticks closer to debt ceiling deadlines. Investors should instead consider an overweight allocation to precious metals as well as non-US safe haven currencies and bonds.
These ought to rally as concerns about a possible US default boil over, at which stage some investors may want to take profit and pursue tactical opportunities. For instance, T-Bills maturing not long after the x-date would likely be unloved, as occurred in 2011 and 2013, presenting an attractive prospect for those willing to bet that Congress will manage to raise the debt ceiling in time.
However, any compromise struck between the Republicans and Democrats is likely to include spending cuts and possibility even tax hikes. Either of which would exacerbate the recession we expect to materialise later this year. Still, it would be a small price to pay if it meant avoiding the widespread and long-lasting damage that a full-blown US default would inflict.
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