How would the market react to a US default?

Despite all the political rhetoric around the debt ceiling, we believe US default is a very unlikely outcome. Here’s our rationale.
Western Asset

Western Asset Management

Spreads of credit default swaps (CDS) on US sovereign risk have moved materially higher in the past few weeks. Is a US default a real possibility?

We believe a US default is a very low probability event. The only time the US “technically” defaulted was in 1979 when a word processing backlog resulted in the delayed payment of maturing US Treasury (UST) bills. Moreover, Congress has raised the debt ceiling 78 times since 1960; 49 of these under a Republican president and 29 under a Democratic president.1 All that stated, markets are bracing for the possibility of a standoff that lasts deep into the 11th hour, an outcome that harks back to 2011, 2013 and 2021. In each of those three episodes, Congress averted a default, but not without roiling financial markets. Today’s supercharged political partisanship—with Republicans controlling the House of Representatives and Democrats controlling the Senate and the White House—has only served to heighten market concerns that we might not see a political compromise on the debt ceiling. This fear partially explains the recent spike in US CDS spreads.

Bear in mind, though, that the CDS market for sovereign risk mostly comprises emerging market countries such as Argentina, Brazil, Mexico, Russia and Turkey. The US CDS market is relatively new and much smaller in size, especially when compared to that of USTs. For instance, on a net basis, the size of outstanding US CDS contracts is estimated at $5 billion versus the estimated size of $73 billion for the May 15, 2050 UST bond,2 which are the cheapest-to-deliver bonds on those contracts. The illiquidity of the US CDS market (with only non-US banks allowed to make markets on these contracts) and the fact that the cheapest-to-deliver bonds are much more heavily discounted today help to explain why US CDS spreads across various tenors have moved materially higher since the beginning of the year.3 For instance, 1-year US CDS spreads have widened out to 155 basis points (bps) as of May 5, 2023 versus 18 bps at December 31, 2022. Spreads on 3- and 5-year US CDS spreads have widened out by 70 bps and 42 bps, respectively, during the same time period.4

What is the “x-date” and what happens if the debt ceiling isn’t raised by then?

As context, the US technically hit its $31.4 trillion debt limit on January 19,5 which means that the government cannot technically issue any new debt. Since then, the Treasury has been using various “extraordinary” accounting measures to pay the government’s obligations in full and on time. Market pundits are now trying to estimate the “x-date,” which is the date when the US runs out of funds to meet its obligations, taking into account the use of extraordinary measures. Treasury Secretary Janet Yellen’s recent comments suggesting that June 1 could be the x-date unnerved markets (given the Congressional Budget Office’s earlier estimates that extraordinary measures would likely be exhausted sometime between July and September), but it’s important to note that the x-date is highly dependent on the timing and amount of incoming federal tax receipts. Estimating the x-date is particularly complex this year due to the delay in the tax-filing deadline for Californians impacted by winter storms.

If the debt ceiling isn’t raised by the x-date, we expect the Federal Reserve (Fed), which acts as the fiscal agent for the Treasury, to follow the blueprint it crafted in 2011. The aim of that blueprint was to “prioritize” interest and principal payments on federal securities over Social Security payments, salaries for federal civilian employees, military benefits, unemployment insurance as well as other obligations.6 The Fed also has contingency plans in place (e.g., via money market operations) to deal with market disruptions in the event of an imminent default. The Treasury itself could take other forms of action to avoid a default by raising cash through either the minting of a special large-denomination coin (which would be deposited at the Fed with the funds used to pay the government’s obligations until the debt ceiling is raised), selling gold or by issuing new debt via Section 4 of the 14th Amendment of the Constitution—the Public Debt Clause explicitly states that “the validity of the public debt of the United States, authorized by law … shall not be questioned.” However, we would emphasize that pursuing such alternatives carries unknown political and economic costs.

How would the market and rating agencies react to a US default?

We believe a default on any Treasury payment would precipitate a severe market reaction with market volatility approaching or even exceeding levels observed during the 2008 global financial crisis. In such a scenario, we would anticipate that Congress would move quickly to resolve the situation; however, a default would call the relative economic and political stability of the US into question.

The impact of such an event on UST yields would be varied but ultimately we expect yields would move lower. For instance, if a default were to trigger a rating downgrade, there could be some forced sellers which would push UST yields higher. However, the confidence hit to the US economy (and its ripple effect across global financial markets) as well as flight-to-quality dynamics would, in our view, overwhelm any selling activity and consequently push UST yields lower.

The following table summarizes each of the rating agencies’ views regarding what would happen in the event that the US Treasury misses an interest payment.

Exhibit 1: US Ratings Summary

Sources: S&P, Fitch, Moody’s, Morgan Stanley Research. As of February 28, 2023.

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Western Asset is a globally integrated fixed-income specialist with an ability to combine global insights with local market opportunities. Find out more here

Endnotes: (1) Source: US Department of the Treasury. (2) Source: Benzoni, L., Cabanilla C., Cocco, A., and Kavoussi, C., “What Does the CDS Market Imply for a US Default?,” Federal Reserve Bank of Chicago, April 21, 2023. (3)“This bond was issued at a price close to par on May 15, 2020, at the peak of the Covid crisis, with a coupon rate of only 1.25%. Since then, the Federal Open Market Committee (FOMC) has repeatedly increased the federal funds rate, resulting in a marked increase in long-term Treasury yields and a corresponding decline in the prices of notes and bonds, especially those with long maturity that make low coupon payments.," Federal Reserve Bank of Chicago, "What Does the CDS Market Imply for a U.S. Default?," April 2023. (4)Source: Bloomberg. (5)Source: Congressional Budget Office, February 2023. (6)Source: FOMC conference call transcript, August 1, 2011. Definitions: One basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%). A credit default swap (CDS) is designed to transfer the credit exposure of fixed income products between parties. The debt ceiling refers to the maximum amount of monies the United States can borrow. The debt ceiling was created under the Second Liberty Bond Act of 1917, putting a "ceiling" on the amount of bonds the United States can issue. WHAT ARE THE RISKS? Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors. U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities. This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal. Data from third party sources may have been used in the preparation of this material and Franklin Templeton ("FT") has not independently verified, validated or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction. Issued by Franklin Templeton Investment Management Limited (FTIML). Registered office: Cannon Place, 78 Cannon Street, London EC4N 6HL. FTIML is authorised and regulated by the Financial Conduct Authority. Investments entail risks, the value of investments can go down as well as up and investors should be aware they might not get back the full value invested.

Western Asset
Fund Manager
Western Asset Management

One of the world’s leading global fixed income managers. Founded in 1971, the firm is known for team management and proprietary research, supported by robust risk management and a long-term fundamental value approach


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