The critical date is still regarded as 2 August 2011 (although tax receipts have been ahead of expectations in July, so technically I guess the date could be stretched out a little further). As we mentioned in a previous email, the debt ceiling of $14.3 trillion was actually reached around 16 May. Since then the government has been effectively dipping into federal pension funds to give it room to pay its bills.
Once 2 August is reached (assuming that is the critical date) and the debt ceiling has not been increased, a notice of non-payment would be issued by the US Federal Reserve (The Federal Reserve is the bank of the US Treasury Department). This notice would indicate that the government’s account at the Federal Reserve is in overdraft (and in violation of the Federal Reserve Act). The immediate payment concerns include:
- On 3 August around $23 billion in Social Security benefits payments are due to be processed.
- On 4 August the Treasury Department must pay $87 billion to investors to redeem maturing Treasury securities.
- On 15 August more than $30 billion in interest payments are due.
- US government normally pays $5 billion to $10 billion every day to defence contractors, Medicare providers, federal employees and others.
In total the US government makes more than 70 million payments a month, so even having a selective non-payment would be a nightmare to administer. It is estimated that once the government runs out of cash and lacks the power to borrow, it would need to cut spending immediately by as much as 44%. The US currently borrows more than 40 cents for every dollar it spends.
One idea being discussed is that the US Federal Reserve could lend money to the Treasury. The Treasury has reserves at the Federal Reserve, which may be released back to the government.
Alternatively, the Federal Reserve could create a loan to the Treasury by printing money – a form of inflationary quantitative easing. Both proposals would clearly indicate a desperate situation, and are unlikely to be well received by the markets.
What would be the implications of the US government defaulting on its payments: in a sentence “the world’s safe haven will have just become high risk”.
- The credit rating agencies would be forced to record the non-payment as a selective default and downgrade the US’s credit rating from AAA to probably AA, with a negative outlook. Standard & Poor’s has said that any missed payments, such as social security payments, would trigger a rating downgrade. (CDS market would also be heavily impacted).
Importantly, a default on payment does not suggest that the US government cannot find a willing lender. It means that Congress has decided not to pay its bills, and one would assume that even if the deadline is missed, the non-payment will prove to be temporary. However, the ratings downgrade would not be temporary and would probably follow the recent UK example, where a programme of fiscal discipline had to be implemented and proven before the rating outlook was adjusted back up.
- Some pension and investment funds that are obligated to hold only AAA rated instruments would become forced sellers of US government bonds and treasury bills, effectively driving interest rates higher.
- It is also likely that other bond investors would become sellers, including some money market funds, private sector mutual and pension funds, as well as foreign investors. Foreigner’s now hold about 50% of all US Treasury securities. However, China and Japan are the largest foreign holders of US debt and would probably no want to add to the market volatility and uncertainty given the nature of the default. Other central banks within the G20 would probably also act in a similar way.
- Most of the US government debt is held by US public sector pension funds, who would most likely also adopt a wait-and-see approach.
- Credit markets would struggle to function as smoothly since US treasuries are used as collateral in many transactions, and they might no longer be as easily accepted – or at least re-priced.
- The currency markets would most likely accelerate the selling of the US Dollar that has been underway recently. The role of the Dollar as the Reserve Currency would be very actively debated, and the Swiss Franc would probably continue to gain strength.
- An extended period in default would throw the already weak US economy back into recession as social services and pension cheques don't go out, civil servants don't get paid and companies that rely on US government contracts and services see their revenues fall. Federal Reserve Chairman Ben Bernanke has called the failure to raise the debt limit "a recovery-ending event."
- The increased uncertainty and worry about the impact on the US and global economic recovery would likely see a sharp sell-off in global equity markets, and a further rise in the gold price. With the euro zone facing its own debt problems and gold prices already soaring, there would be a limited number of places to hide. That, in turn, would hurt already fragile pension funds and similar retirement investments and undermine consumer confidence and the willingness to spend.
- The prospect of a slowing economy should mean commodity prices would fall on speculation of lower demand, but that might be mitigated somewhat as traders move into commodities as a tangible store of value.
I certainly hope that common sense prevails as we head towards 2 August!
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