Discussions that could determine whether the US ‘runs out of money’ and defaults on its national debt are due to take place today, posing risks of turbulence to financial markets.
The risk of default is said to be low, but the polarised nature of American politics makes the subject complex.
Today, President Joe Biden and other congressional leaders were due to meet and negotiate budget details that might appease Republicans, who otherwise could block further borrowing. Republicans could prevent the ‘debt ceiling’ from being raised unless the Democrat government agrees to certain measures, such as scaling back on spending.
Failing to get the ceiling raised could see the government having to prioritise debt repayments and default on some of its national debt.
But it is not the first time the US has been here. Beat Thoma, CIO at Fisch Asset Management, says the wrangling of the US debt ceiling is almost a “ritual”. However, Thoma adds that market data suggests investors fear a low - but increasing - probability of default.
Republican and Democrats are in a ‘Game of Chicken’, says Thoma. In other words, they are like two cars hurtling towards each other, hoping the other will swerve first. Disaster could ensue if neither moves.
Financial markets are preparing for potential turbulence, says Thoma, and Treasury Secretary Janet Yellen warned that the ‘X-date’ – when the Treasury might run out of money for some of its spending obligations - could come as early as June 1, which Thoma says is earlier than most analysts had expected.
Meanwhile, the US failing to raise the debt ceiling and defaulting on its financial obligations would be the “ultimate gift” for China, says Nigel Green, the chief executive of deVere Group, a wealth management company.
A default on June 1 would cause a “global economic catastrophe” if the ceiling is not raised by Congress before then.
“A default would upend the global financial system and would likely be worse than the 2008 crash,” says Green.
Ultimate gift
But it would also be the “ultimate gift for China”, according to Green.“A default would lead to a decline in the value of the US dollar and a loss of confidence in the US financial system. As such, investors would seek alternative destinations for their capital.
“China would move to position itself as a more stable and attractive investment option, attracting more international investment and capital inflows. In turn, this would boost the Chinese economy and financial markets.”
Using it foreign exchange reserves, says Green, China would likely take advantage of the depreciation of US asset prices, including real estate, companies, and infrastructure, by purchasing these assets at discounted prices.
Strategically, China could assets in sectors like technology, energy, or manufacturing, while a stronger yuan would undermine the US dollar as the primary reserve currency, Green adds.
Francesca Fornasari, head of currency at Insight Investment, said the asset manager’s view is - “with some last-minute brinkmanship” - the ceiling will be raised – but that a technical default would boost currencies including yen and the Swiss franc.
Finally, Chris Iggo, a chief investment officer at Axa Investment Managers, says the risk of default is low but not non-zero and offers some market data to illustrate investors’ feelings.
He points out that Treasury Bills that mature just before June 1 are trading with a yield of around 3.8% to 3.9%, while those that mature after this possible X date have yields of around 5.2%. The dollar, he adds, has weakened already, and the dollar index was recently trading near its lowest levels of the past year.
More dramatically, he says, the one-year credit default swap on US Treasuries is currently trading at 180 basis points compared to an average of 10 to 15 basis points in the past.
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