With the October 17 debt ceiling “deadline” approaching, both parties are holding firm and trading indignant press conferences.
So while markets are still relatively complacent, we were wondering what would happen in the disaster scenario: a true default.
That is, what happens if we fail to raise the debt ceiling, run out of cash, and the President or Treasury cannot/will not gimmick its way into making payments?
On or around October 31, Goldman Sachs estimates that Treasury will have insufficient cash.
At that point, “The worst case scenario is a real default recognised by rating agencies,” Brown Brothers Harriman’s Marc Chandler told Business Insider. If we choose to default, ratings agencies would likely give the U.S. a rating of “selective default.” As HSBC noted, sovereigns that have been SD in the past normally end up as sub-investment grade — CCC+ to B — and the thought of the world’s wealthiest country falling to that level is almost “farcical.”
“A real genuine default will have ripple effects.”
Chandler says the government can probably miss a payment for a few days, but eventually a “true default” would mean that businesses who contract for the the federal government will not get paid. That would spook markets even more than simply crossing the October 17 threshold.
Stocks would also surely tumble. Deutsche Bank’s David Bianco — who admittedly said the the likelihood of this scenario happening is 0% — calculated that the S&P would lose about half its value.
And say goodbye to 4.2% of GDP growth, according Goldman Sachs economists Alec Phillips and Kris Dawsey.
“It would be very messy and it would hurt a lot of innocent people,” Chandler said, adding that corporate bonds and our close trading partners Canada and Mexico would also take a hit.
“Since we’ve never seen a debt default for the world’s reserve currency we are talking about something that has no precedence and as such is impossible to model,” said Gluskin-Sheff’s David Rosenberg. “It is a known risk so it is not a Black Swan, but we have no experience in measuring the consequences.”
“Perhaps a template would be the pricing action that took place ‘ahead of the event’ in late summer 2011 but this time the effects are likely to be amplified,” Rosenberg said.
“In terms of a market call, I would be stunned if gold did not break out massively to the upside if we get beyond October 17th without a resolution.”
Bond expert Tom Digaloma, managing director at ED&F Man Capital, said that his default scenario would mean a sell-off in the 10-year treasury back to 2.8-2.85% yield.
“I also believe the front-end [0-3yr] could rise 10-15 bps as panic selling ensues from central banks and corporate cash accounts,” he said.
Digaloma thinks the odds of default are rather low, but “anything cant happen when politicians are in control.”
PIMCO’s Mohamed El-Erian gave us his “worst case scenario.”
Risk assets would likely come under greater pressure, reacting to every signal out of DC. Meanwhile, normal market functioning, including the important repo function, would be subject to growing strain and stress.
In the weeks that follow, the Treasury Department would be forced into a very delicate and challenging process of payment prioritization or delaying some payments outright. In either case, officials would probably seek to protect to the maximum extent possible the full faith and credit of the nation. As other spending commitments are cut very hard, equities would sell off significantly on concern of a major recession while Treasuries would likely out-perform.
If this process is drawn out — and, remember please, we believe that the probability of getting to this stage is very, very low — the U.S. could default on debt payments. While it would be doing so due to the lack of political willingness rather than financial ability, the result would be the same: The world would most likely be facing the likelihood of a great depression.
Richard Bernstein, CEO of Richard Bernstein Advisors and former Chief Investment Strategist of Merrill Lynch, put it simply: “All I’ll say is that politicians always talk about protecting future generations. Well, if you want to HURT future generations there is no simpler way to do so than just defaulting on the debt.”
“No country in history has ever gotten a cheaper cost of capital by defaulting,” Bernstein concluded.