What the markets say about the risk of default

The headlines have been warning for weeks about a possible default by the United States. Negotiations are underway, but they face a deadline that could come on June 1.

Since government bonds are the hub of the global financial system – the “risk-free” assets on which everything else is based – the consequences of a US debt default would be bad, if not catastrophic.

But how likely is it that this will actually happen?

President Biden and Chairman Kevin McCarthy both say they understand that bankruptcy would be a disaster, and they don’t expect it to happen, but until legislation is passed to lift the debt ceiling, the outcome is uncertain. And the markets carefully weigh the opportunities.

In a nutshell, they predict a default is most likely will not happen, but they nevertheless suggest that catastrophe is still all too possible, with the odds quickly adjusting as the news shifts. If a final solution is not reached soon, the relative calm that reigns in the markets could quickly disintegrate.

I noted last week that US default insurance costs have skyrocketed. As the deadlock around the debt ceiling looms, we see the United States in trouble $30 trillion credit default swap market as a riskier borrower than countries such as Bulgaria, Croatia, Greece, Mexico and the Philippines. Compared to Germany, the cost of insuring US debt is about 50 times higher.

But as several readers pointed out, I didn’t say what the numbers tell us about how risky US bonds have become. This is not a trivial matter. So here’s a closer look.

What’s at stake

As Washington politicians negotiate to prevent a government debt ceiling breach, Wall Street and US government agencies prepare for a wide variety of troubling events.

Even listing the possible effects of a default is disturbing. They can range from a manageable event, consisting of a missed payment on a specific Treasury bill affecting a fairly small number of creditors, to something much more catastrophic: the suspension of all Social Security checks and debt payments by the US government, accompanied by a sudden collapse of the world markets and a recession.

Like former Secretary of the Treasury Jacob Lew said last month at a meeting of the Council on Foreign Relations: “I think it’s pretty safe to say that if we defaulted, the likelihood of a recession is almost certain.”

What treasury prices tell us

Current short-dated government bond pricing suggests that traders believe there is a reasonable possibility that the US Treasury will miss a payment of interest or principal on securities maturing in early June. That’s when Treasury Secretary Janet L. Yellen says the United States will likely exhaust all “extraordinary measures” that have kept government borrowing below the debt ceiling.

Concerns about what could happen in the early days of June are the main reason for an anomaly in Treasury yields. Money market fund managers nervous about a possible default shun Treasury bills that are currently maturing, lowering prices and driving yields 0.6 percentage point higher than Treasury bills maturing in July. It is assumed that some degree of normalcy will have returned by August and September, and that factors such as inflation and the Fed’s interest rate policy will regain their usual dominance. Yields for bills maturing later in the summer and early fall are higher than those in July. This halter pattern is unusual.

It entails two things. First, the markets believe there is a real risk of default in early June. Second, the possibility of a long-term the failure of the United States to pay its bills is considered extremely low.

That’s because the problem is fundamentally political, not financial.

The markets will provide the United States government with all the money it needs, if only Congress authorizes it to borrow. The treasury market is the deepest and most liquid in the world. Demand for government bonds is robust and likely to remain so as long as the creditworthiness of the United States remains unaffected.

But a US debt default could change all that, and another US debt downgrade, as was the case in 2011 when the United States nearly went bankrupt, could raise US borrowing costs.

At the root of the dispute is a fundamental reality: the country spends much more money than it takes in, in taxes and other revenues. To pay its debts, the government has to borrow regularly by issuing large amounts of Treasury bills. This implies a rising debt ratio.

It is a loaded subject for many people, including former president Donald J. Trump, who had huge deficits during his own presidency but now argues for major cuts.

Republicans should be pushing for trillion-dollar cuts now, Mr. Trump said last week during a live town hall hosted by CNN. If the White House disagrees, he said, “you have to make a default.”

Mr Biden has said long-term fiscal issues should be treated separately from the debt ceiling, which is just a formality. Nevertheless, negotiations are underway and Speaker McCarthy insists that a final deal must include long-term austerity measures.

Most economists say that when borrowed money is used productively and borrowed at a reasonable rate, deficits need not be a problem. The details are important. But paying America’s debts quickly is essential to the proper functioning of financial markets.

What Credit Default Swaps Say

Currently, the stock market and the wider bond market are treating debt ceiling negotiations as a non-event. Other issues predominate: continued inflation, high interest rates, bank failures, the possibility of an impending recession and a pivot by the Federal Reserve after more than a year of tightening financial conditions.

The debt ceiling impasse in the summer of 2011 was different. After that, the shares fell sharply.

There has been no similar action in the stock market to date, and that may be partly because the credit default swaps market sees the current situation as less risky than the 2011 crisis.

Credit default swaps are a form of insurance. When the prices, or “spreads,” of these securities increase, they reflect the market’s view that the underlying bonds, in this case Treasuries, have become riskier. These spreads can be used to derive accurate default predictions,

At its worst point in 2011, swap pricing implied a 6.9 percent probability of a US debt default, according to Andy Sparksmanaging director and chief of portfolio management research at MSCI, the financial service provider. This year, the swap market’s gloomiest forecast came around May 11, when Mr. Trump made his remarks. The default rate then reached 4.2 percent. With the news about the progress of the negotiations, it fluctuates around 3.7 percent.

That’s a huge increase since January, when the probability of default was almost zero. But while swap spreads are now much wider for government bonds than they were in 2011, savvy market participants know that when calculating implied default probabilities, another important factor also counts: the price of the underlying bonds.

This is often misunderstood, as Mr. Sparks explained. “It’s important to realize that the spread is only part of the probability calculation,” he said.

This is crazy, but important: due to high inflation and rising yields, bond prices, moving in the opposite direction, are much lower than bonds of similar maturity in 2011. With current lower prices, the probability of default is lower than in 2011, even though the swap spreads are wider.

In short, the credit default swaps market says investors should be concerned about a default, but probably shouldn’t worry too much, at least not quite yet.

The prediction of a prediction market

A simpler and smaller market gives a higher probability of a default of about 9 percent. This is the Kalshi forecast market. Tarek Mansour, a founder of Kalshi, told me his market “reflected Main Street views, not just Wall Street, that’s all you get from the credit default swaps market.”

Kalshi asks a simple question: Will the United States default on its debts by the end of the calendar year? Anyone can place a bet on this ‘event contract’ for a small fee. Kalshi has a good track record of forecasting inflation and interest rates, and I find the data interesting, but not the last word.

What is the real probability of a US debt default? Given recent history, I would simply say that while the probability of a major disaster is quite small, it is great enough to prepare for.

I keep enough money in safe places in case there is a breakdown, but I invest for the long term. Don’t panic if the stock market drops sharply. That could even be a buying opportunity, as stocks have always risen after previous debt ceiling fears.

With any luck, an agreement will be reached in Washington and these concerns will be contested. Let’s hope there is no need for a new chapter in the history of political dysfunction.