What Would a U.S. Debt Default Mean for Markets and the Economy?
Author: David Stonehouse
May 25, 2023
In part two of a two-part series, AGF’s David Stonehouse discusses the potential economic and capital market impacts if the United States were to default on its debt.
While unlikely, the possibility that the United States might default on its debt obligations due to an inability to raise the debt ceiling cannot be ruled out given the current political backdrop, as my colleague Greg Valliere discussed in part one of this special report.
In part two, we examine the economic and market implications if the U.S. actually does default.
First, it’s important to note that the U.S. Treasury will still receive revenues, just not enough to fully cover all its obligations. However, even the possibility of prioritizing payments won’t be enough to forestall a significantly negative economic impact. Millions of government employees might receive no paycheque (or reduced pay), citizens might not receive their full Social Security, Medicare and other benefits, or bondholders might not receive all their coupon payments, depending on how spending gets allocated.
Second, a default would have wide-ranging impacts on the capital markets, mostly negative, although some of the effects may end up being counterintuitive. Below we consider the consequences for a number of major asset classes.
The U.S. Treasury bill market has already seen substantial turmoil in the past few weeks. T-bill holders typically have high liquidity needs, so they depend on maturing bills to be paid on time. As estimates of the “X date” have shifted, investors have responded by buying bills of shorter maturities than this date, driving yields down by sometimes large amounts (one-month bills dropped all the way from 4.5% to 3% in April) while shunning longer-dated bills, whose yields rose from 4.5% to over 5%. If U.S. Congress passes an extension to October 1, for instance, expect three month yields to drop while longer-dated bill yields rise further.
Credit markets are likely to reflect the economic pain and uncertainty through widening spreads, resulting in falling corporate bond prices. Investors would be worried that corporate cash flows might decrease, hampering their ability to service their debt.
Equity markets would likely decline by fairly meaningful amounts (at least single digits for a temporary stand-off, potentially double-digit drawdowns in the event of a more prolonged impasse). As Greg noted, it’s perhaps surprising that stocks have been relatively resilient so far. This may be explained by the fact that the debt ceiling has always been raised in the past, even if it came down to the wire a few times, and also the expectation that cooler heads will prevail given the stakes and the consequences. However, the tenuous majorities in the House and Senate, coupled with the presence of far left and far right legislators with less desire to compromise, may make this situation different. It may ultimately take a large drop in equities to force Congress to resolve the issue.
Government bonds are more difficult to predict. Some believe that yields would rise due to deteriorating faith that the U.S. would pay all its debts on time, or due to the credit rating downgrades that would likely ensue (much as when S&P downgraded U.S. debt in 2011). However, the resulting economic slowdown might cause investors to embrace the traditional safe haven of government bonds.
Also, if the U.S. Treasury were to prioritize payments, it’s likely that bondholders would be at or near the top of the list, which itself would be more supportive of bonds than initial expectations would suggest. While the near-term moves would likely be volatile but perhaps less dire than many investors expect, the longer-term impact might not be so favourable regardless of whether the debt ceiling is extended, as we’ll touch on below.
The outcome for the U.S. dollar is another intriguing area that may be hard to discern. Logically, a default would reduce faith in the dollar much as it would in government bonds, causing the dollar to fall. However, there are no ready substitutes for the dollar as the world’s reserve currency, and furthermore, much like government bonds, it tends to strengthen during times of economic duress. On balance, some strength seems more probable.
Finally, one safe haven that could benefit from a U.S. default might be gold. Historically gold has tended to benefit from disruptive events as well as U.S. dollar weakness should that occur.
If a default were to occur, the magnitude of the impact would be significant, as noted above. However, the duration would likely be short. The fallout from such an event would likely be large enough that the turmoil would likely force politicians’ hands, resulting in a fairly quick compromise. In addition, the government would almost assuredly make its creditors whole (not just bondholders but all employees, beneficiaries, etc.) by paying interest in arrears.
On net, investors should anticipate a stock market rally if a debt default is averted, while in the event of a default-induced equity sell-off, a subsequent rebound is highly probable as soon as the debt ceiling is renegotiated.
One final point should be noted: it may not be the brinksmanship of negotiations and even temporary default that is the final chapter of this saga. It is likely that whatever compromise is eventually reached results in a not-insignificant amount of spending cuts, which will slow economic growth in subsequent periods.
In addition, the Treasury may have to borrow heavily to resume its deficit financing needs and catch up to its prior pace of debt issuance, while the Fed could maintain its quantitative tightening program to drain pandemic-era liquidity injections. These factors would likely result in fiscal and liquidity headwinds of hundreds of billions of dollars or perhaps even more in the first few quarters after the debt ceiling resolution. This outcome has the potential to slow economic growth while also pushing up bond yields at the margin, which could weigh on equities and corporate bonds even as we put this unpleasant episode behind us.
The views expressed in this blog are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.
Commentary and data sourced from Bloomberg, Reuters and company reports unless otherwise noted. The commentaries contained herein are provided as a general source of information based on information available as of May 23, 2023 and are not intended to be comprehensive investment advice applicable to the circumstances of the individual. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change and AGF Investments accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained here.
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Written by
David Stonehouse, MBA, CFA®
SVP & Head of North American and Specialty Investments
AGF Investments Inc.
