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Investors prepare for a painful crash to the US debt ceiling

M.most of It is considered a fundamental axiom of the financial system that the United States cannot default on its debt over time. Investors are always ready to lend money as the country issues the world’s reserve currency. And if you can borrow more, you can pay off the debt.

But Washington is once again reminding the world, with sheer indifference, that debt defaults can indeed happen. A political device that imposes severe restrictions (currently $31.4 trillion, or 117% of the U.S. gdp) total government borrowing. Next, Congress must agree to raise or waive the cap to prevent the Treasury from failing to pay its bonds or failing to meet its spending obligations, such as Social Security. This time, Treasury Secretary Janet Yellen warned that the government could run out of cash and accounting manipulation as early as June 1. On May 9, congressional leaders met in the Oval Office with President Joe Biden to enter the first phase of negotiations. They are far from trading.

Thus, the stage is set for a brink game for the Republican-controlled Congress to try to extract concessions from Mr. Biden. Both sides will almost certainly find a way to avoid catastrophe. But as the Washington standoff heats up, Wall Street’s best talent is less inclined to get involved.

To understand why, think about what default means. Short-term government bonds, or “t-bills,” are the closest thing to a risk-free asset. This makes it popular with corporate cash managers (who want super-safe returns) and traders who need to post collateral (who need to hold value and be able to sell easily). If governments stiffen corporate treasurers, businesses will fail to pay each other and the wheels of commerce will come to a painful standstill. Once traders’ collateral disappears, financial contracts for all stripes begin to collapse, creating chaos in global markets.

So it’s no wonder investors are rushing to protect themselves. Demands for sovereign bonds to mature before defaults have caused huge swings in yields on the world’s safest assets. His one-month bill yield in early April was 4.7%. Over the next three weeks he fell to 3.4%, even as the Federal Reserve prepares to raise interest rates to 5-5.25%. However, it is the one-month maturities that mature after June 1, when the Treasury may have run out of cash. Demand plummeted as a result, and in a matter of weeks, harvests surged by more than two percentage points. One trading boss explained that he tried to have his team manually override the settlement software so that unpaid and matured bills would not simply disappear from the system.

Under the assumption that an actual default would shock politicians’ obstinacy and be quickly rectified, long-term government bonds have looked safer so far. Yet even they are not immune. The cost of insuring a 5-year Treasury bond against default was once the very definition of throwing money away, but in the last 12 months it has quadrupled (in fact, the lack of market liquidity explained in part by).

what next? If you think Washington can’t possibly care about a cliffhanger, it’s time to buy a T-bill at a discount and sell pointless bond insurance to the nervous. you may end up The deal will be followed by a massive issuance to rebuild the buffer as the Treasury will deplete its cash reserves to virtually nothing. In other words, even the best-case scenario could drain the market of liquidity and drive up yields.

Meanwhile, the stock market looks volatile either way.Analyst Pimcoasset managers have, over the past decades, specification The 500 Index is down an average of 6.5% in the months leading up to the debt ceiling. Under default it would be much worse. In 2013, during the previous debt ceiling standoff, Fed officials simulated the impact of a month-long default.

In the meantime, expect traders to get even more nervous. American politics will discourage early trading, and it is quite possible that markets will sway to force it. Default remains the least likely outcome. But it’s no longer unthinkable as investors are keenly aware.

https://www.economist.com/finance-and-economics/2023/05/10/investors-brace-for-a-painful-crash-into-americas-debt-ceiling Investors prepare for a painful crash to the US debt ceiling

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