It’s very difficult to contemplate the market reaction of a US default (which we mean strictly as missing an interest payment on US debt) in part because A) no entity anywhere near the significance of the US has defaulted before and B) a default theoretically would hurt US Treasuries, which are typically what people buy in a state of panic.
For those not familiar with this pattern, here’s a chart of the VIX (volatility, blue line) and the inverse of US borrowing costs (red line). When volatility surges (as frequently happens in a panic) people buy Treasuries like crazy.
It seems safe to assume that a default would cause a major crash of risk assets (stocks, etc.), but what about Treasuries?
The presumption is that a default causes a spike in rates, but that assumption is due in part due to thinking of the US as a normal ‘credit’ (for most entities a default would be associated with a rate spike).
But a rate spike in a panic would be exceedingly abnormal. SocGen’s Kit Juckes aptly put it in a tweet.
— kit juckes (@kitjuckes) January 13, 2013
Of course we really don’t know what would happen. It would be unprecedented in modern finance.