My best guess today (and it’s only that) is that we will avoid reaching the X-date (the date on which the U.S. will default unless the debt ceiling is raised) with the current stalemate unresolved. And I have even less of an idea of what will happen in the financial markets should my guess be wrong.
One thing that might, paradoxically, is that the price of U.S. government debt might actually increase.
Why? Kate Duguid and Colby Smith of the Financial Times explain:
Riskier assets such as US stocks and corporate bonds would face large losses. US bonds and the dollar are traditionally haven assets for investors in volatile periods so, paradoxically, they may rise in value immediately after a default — even though the default would be on US debt. That is because investors say the willingness and ability of the US to pay its bondholders is ultimately not in question.
A lot may turn out to hang on that word “ultimately,” particularly outside of the financial markets, for example for firms doing business with the government wondering how to manage their cashflow while the impasse drags on.
But flip back to the financial markets for an interesting angle on the credit-default-swaps market. As I wrote the other day, credit-default swaps are a way for lenders/investors to buy “insurance” against a borrower’s default, and the price of one-year CDS insuring against a U.S. default has been running at historically high levels, higher even than peaks seen during the financial crisis. As I mentioned in that post, there are reasons why that may mean less than it may seem (the market in one-year CDS is not particularly liquid, CDS can be traded speculatively, and so on). On googling, I also see that in 2013 I linked to something written by Felix Salmon on this topic, much of which in turn referred to what he had written in 2009. What goes around . . .
However, if the U.S. does default (a word that, for these purposes, will have a carefully lawyered meaning), Duguid and Smith point out that some CDS holders may do very well indeed:
For holders of insurance on US government bonds, the price of which has risen to record highs recently as default fears have grown, a potentially enormous payout awaits.
Credit default swaps are contracts between two market participants, one of whom agrees to make a payment if the issuer defaults on its debt. The size of that payment is in effect the difference between the original value of a bond and its current market value.
The bond used to determine that payout is typically the cheapest one on the market issued by the borrower. The difference in price between the cheapest bond on the market and the one for which the insurance was purchased is not always huge. But for a US default it is, because the steep rise in interest rates since early 2022 means there are Treasury bonds in circulation that are trading at a large discount — below 60 cents on the dollar.
That could mean an enormous return for holders of CDS, provided that the US does not make a payment on its bonds within three days, the grace period allowed by the International Swaps and Derivatives Association.
For those buying protection via CDS, “if (they) get lucky and [Washington] DC screws up, (they) get to settle against this really cheap bond that wouldn’t normally exist except we’ve had this enormous increase in interest rates”, said Peter Tchir, head of macro strategy at Academy Securities. “The payout is going to be much higher than it has been in the past, because of interest rates.”
Doubtless a lot of hedging of positions will have been going on, but reading about the potential for an “enormous return” always makes me think of those who are on the other side of such a trade.
It could be something, it could be nothing, but it’s a reminder that if there truly is a default, we will be in a zone where something somewhere could go very badly wrong indeed.
As a reminder, it is possible to believe (1) that the U.S. is on a fiscally unsustainable course and (2) that a default must be avoided.
What a mess.