Even though both President Joe Biden and House Speaker Kevin McCarthy (R-Calif.) have said in recent days they don’t believe the debt ceiling negotiations will end in a fiasco and trigger an economically damaging debt default, markets are jittery and voters nervous as they mull the implications of America failing to meet its debt obligations.
As the deadlock in Washington grinds on and the country slides closer to the so-called X-date, when the Treasury Department’s bag of accounting tricks (known as “extraordinary measures”) runs out and the government faces the prospect of a debt default, markets have shown a non-trivial risk of default.
For starters, spreads on 5-year credit default swaps (CDS), one market-based measure of default risk, have widened to 69.76 on May 19, the highest in over a decade and reflecting a 1.16 percent implied probability of default.
That’s roughly consistent with a recent estimate by analysts at the Federal Reserve Bank of Chicago, who said in a recent projection (pdf) that the market-implied default probability was around 1 percent around the end of April. While those odds may not seem high, they’re far greater than the 0.2 to 0.3 percent in 2022, per the Fed’s estimate.
Meanwhile, analysts at MSCI Research said in a recent note that, as of May 3, there was a 3.9 percent probability of default. Their methodology is based on one-year swaps on U.S. government debt combined with deliverable price factors. By comparison, the debt ceiling crisis of 2011 saw a 6.9 percent implied probability of default, per the MSCI analysis.
Yet another default gauge, the Kalshi prediction market, lets investors bet directly on whether the U.S. government defaults on its debt. Currently, it shows an 8 percent probability of default.
But whatever the odds of a default, the possibility that it might come is clearly on voters’ minds as they consider the implications.
Voters Say a Default Would Worsen Economy, Crash Markets
Recent polling shows that most voters are aware of the looming X-date, while at least 7 in 10 think a default would worsen the economy, lead U.S. stock markets to drop substantially and make borrowing more costly.
A recent survey by Morning Consult (pdf), carried out between May 8 and May 11, showed that a strong majority of U.S. voters (67 percent) said they’ve come across either “some” or “a lot” of information about the debt ceiling deadlock and its implications for a default. remove
While most voters (71 percent) think that a default would be a “major” problem for the U.S. economy, a far slimmer minority (39 percent) believe that a debt default would affect them personally.
At the same time, 80 percent said they think that a default would “worsen” the economy, while 75 percent said they think stocks would “decline substantially.”
Another 73 percent said U.S. Treasury yields would rise and make borrowing more expensive, while 72 percent said they believe the United States would lose its standing as a financial leader in the global arena.
At least six in ten voters said that a default would lead to “widespread” job losses all across the country and that the government would be unable to pay veteran and Social Security benefits.
A slim majority (53 percent) said they would be in favor of Biden using executive powers to prevent default if negotiations fail and Congress does not raise the debt cap before the X-date arrives.
The Treasury Department on Monday reiterated its expectations that the so-called “extraordinary measures” (basically accounting maneuvers) would run out by the end of the month and, by June 1, the government would be unable to pay its bills.
Is a Compromise Imminent?
Negotiators for the White House and congressional Republicans were set to continue discussions in Washington on Friday in a bid to find common ground on lifting the $31.4 trillion debt ceiling, though there’s been no word on any breakthrough so far.
Republicans, who have tied lifting the debt cap with spending cuts, have been trying to persuade Democrats to accept tougher work requirements for some federal aid programs, as well as expenditure reductions.
The GOP legislative proposal pairs lifting the ceiling by $1.5 trillion with $4.5 trillion in spending cuts over a decade.
Biden and the Democrats have so far insisted on a “clean” bill with no preconditions to lift the ceiling, though they’ve expressed openness to discussing spending cuts as a separate matter.
However, there has been media reporting based on anonymous sources that White House officials believe that Biden is prepared to compromise with Republicans to some extent on some demands to rein in spending.
McCarthy earlier this week again called for a compromise and warned that Biden’s refusal to budge meant the president might “bumble his way into a default.” The California Republican also joked that Biden’s “secret plan” could be to wait until the last minute to pass the GOP legislative proposal.
Before negotiators met on Capitol Hill on Thursday to try and hammer out a deal, Biden said he’s “confident that we’ll get the agreement on the budget and America will not default.”
Meanwhile, White House National Economic Council Director Lael Brainard said Thursday that Biden’s negotiating team had been instructed not to agree to any Republican proposal on lifting the debt ceiling that would result in cuts to health care or increase the poverty rate.
In a sign of how urgent the matter has become, Senate Majority Leader Chuck Schumer (D-N.Y.) said that lawmakers should be ready to return to Capitol Hill on 24 hours’ notice from their recess next week in case a deal is reached and they’re needed to put it to a vote.
‘Risks Taking Down The System’
Analysts at ING believe that there’s more potential for political brinkmanship before a deal is struck.
“The problem is that the personalities involved and their entrenched positions mean it is almost impossible to believe that a deal will happen smoothly and quickly,” they wrote in a note.
“We fear that it will take significant economic and financial market stress to trigger a climbdown from the key players; perhaps a realisation that individuals responsible for any pain will be punished at the ballot box,” they added.
The ING team said that failure on the part of the government to pay even a single U.S. Treasury bond interest payment would risk “contaminating” the entire range of Treasury’s debt offerings to investors.
“That risks taking down the system,” they warned, though they added that this is “highly unlikely” to occur.
“But mistakes can be made,” they continued, pointing to the price action on credit default swaps as a sign of elevated market worry.
Besides credit default swaps flagging a growing default risk, finance leaders on Wall Street have also become increasingly nervous amid the deadlock.
Citigroup CEO Jane Fraser said recently that the negotiations on raising the ceiling are “more worrying” than previous episodes.
JPMorgan Chase CEO Jamie Dimon said the bank is convening weekly meetings to prepare for what could be a major event that shakes markets.
“The closer you get to it, you will have panic,” Dimon told Bloomberg TV last week. “Markets will get volatile, maybe the stock market will go down, the Treasury markets will have their own problems.”
Vice President Kamala Harris said during a conference call for Democrat activists on Thursday that a default “could trigger a recession” and urged them to contact lawmakers to voice their opposition to a default.
Probability of Recession Soars
Besides the threat of default weighing on recession odds, other risk indicators for a possible downturn are flashing red.
The probability that the country will enter a recession within the next year has risen to 68.2 percent, according to the New York Fed, which is the highest level since 1982.
The Fed’s recession risk indicator is now greater than it was in November 2007, not long before the subprime crisis, when it stood at 40 percent.
A recent poll showed that most Americans believe that the country is headed for a recession, while pessimism regarding the U.S. economy has hit a record high.
Besides an elevated risk of recession, inflation continues to be a problem, reviving stagflationary concerns.
Stagflation is a combination of slowing growth and high inflation, a toxic brew that is challenging for Federal Reserve policymakers to grapple with because fixing one (raising interest rates to lower inflation) tends to make the other one worse (higher interest rates slow the economy).
Recent data from the University of Michigan showed long-run inflation expectations rising to a reading of 3.2 percent, the highest level since 2011.
At the same time, consumer expectations about the strength of the economy one year ahead plummeted by 23 percent.
“The University of Michigan survey data disappointed on both US consumer sentiment and long-term inflation expectations. At the headline level, look for this to fuel some #stagflation worries,” Mohamed El-Erian, Allianz’s chief economic adviser, said in a Twitter post.
Still, on an optimistic note, macroeconomic data don’t show an imminent recession.
The Federal Reserve Bank of Atlanta’s real-time GDP estimate notched a reading of 2.7 percent on May 8 before rising to 2.9 percent on May 17.
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