- The CDS and T-bill markets are pricing in heightened risks of US default, albeit a technical one
- Potential consequences include higher costs of borrowing, falling asset prices, tightening liquidity
- It is not our base case that US congress would stand idly by, but markets may still be impacted
- Investors should keep a posture of prudence; focus on high quality equities and fixed income
- Focus on gold as risk diversifier and short-term credit to avoid excessive duration risk
Early sightings of black swans. Conventionally, US lawmakers have never failed to pass a suspension/increase in the debt ceiling before the Treasury ran out of cash to pay its obligations. However, close observation of the bills and derivatives markets reveal that the markets are willing to wager that “past performance is no guarantee of future results”; that the unthinkable scenario of a US default – albeit perhaps a technical one – is not as remote as what history might suggest.
Figure 1: Default expectations for the short term have soared above the long term
Source: Bloomberg, DBS
What are the consequences of a US default? Given that the market is pricing a non-zero risk of US default, investors need to be aware of the non-zero possibilities of its consequences, including:
- Higher borrowing costs. US default pushes up the sovereign curve, which elevates all other borrowing costs that take reference from these rates, including mortgages, credit card debt, auto-loans, and company borrowings, raising risks of defaults.
- Risk-asset price fragility. Similarly, higher risk-free rates would result in valuation contraction across all asset classes due to higher discount rates, which filters to lower consumer confidence through a negative wealth effect.
- Delayed payments. There would be indefinite payment delays to the millions of federal employees, contractors, military servicemen, social security beneficiaries etc, causing a de facto tightening of liquidity conditions.
- Broad financial instability. Treasuries are integral to the global economy, serving as collateral for trillions of dollars of short-term money-market loans and derivatives, while forming the bulk of the high-quality liquid asset bases of major banks. Investor perceptions of higher Treasury risks can also result in failed auctions, and the Fed may be forced to monetise debt to support the financial system.
Armageddon is not our base case. Noting the above repercussions, we believe that it is not in the interest of either side of congress to allow a disorderly default. Additionally, even with US 1Y CDS at c.160 bps, the market implied probability of a credit event is still around 4% – hardly a certainty. Nonetheless, market risk pricing suggests that investors need to remain prudent in their portfolio positioning in the near term.
Stay with quality assets. The debate around the debt ceiling is likely to result in much market volatility over the next few months. The conceivable upshot is that applying fiscal prudence to manage the ballooning US debt would (a) ease inflationary pressure and (b) tighten consumer confidence in the medium term, judging by the contents of the Republican’s "Limit, Save, Grow Act". This implies that the Fed need not hike much further as credit conditions would already tighten in response to such spending cuts. Nonetheless, we believe investors would be better off
- Staying with high quality equities (consistent cash flow, strong balance sheets) and fixed income (A/BBB rated), given that these companies/issuers are better positioned to weather a slowdown,
- Holding gold as a risk diversifier, noting that it stands to gain either way under opposing outcomes of recession and inflation, and
- Remaining with short duration (3-5Y) credit, noting that persistent US debt sustainability concerns would not bode well for long-term obligations.
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