- On Thursday, the Treasury estimates that it will have approximately $30 billion in its account with the Federal Reserve (Fed), and it will need to pay bills from its cash on hand.
- I think the chance of a default is pretty close to zero.
- Unless it gets rid of the debt limit, any deal that is crafted will set us up to see a repeat of this crisis at whatever the next deadline is.
Contrary to what the headlines might have you believe, October 17 is not the deadline to default. It is the day that the U.S. Treasury says it will exhaust the extraordinary measures that have allowed it to get by—since May 19—without breaching the legally imposed limit on federal government borrowing.
On Thursday, the Treasury estimates that it will have approximately $30 billion in its account with the Fed and it will need to pay bills from its cash on hand. However, the Treasury will still collect revenue and it will be able to roll over existing debt at Treasury auctions. Based on cash-flow projections, the Treasury should be able to meet obligations as they come due for about another week. Whether it has enough cash to pay $6 billion in interest to creditors on October 31 is questionable. It is almost certain that its cash on hand won’t cover the November 1 payment that will be due to Social Security recipients, military personnel, and Medicare service providers.
The partial government shutdown may be helping the Treasury’s cash-flow picture slightly but not enough to buy a lot more time. But even if October 17 comes and goes without a deal to raise the debt ceiling, all hope for a resolution may not be lost. The Treasury has a window of about a week during which a deal can be struck before it needs to issue more debt than it already has.
Will the Treasury be able to roll over existing debt?
When Treasury securities mature, the Treasury can issue new debt to replace the old debt—provided that investors are willing to buy it. I don’t think the Treasury will have any problem enticing investors to participate in the securities auctions. For one thing, for a business to participate in the Fed’s open market operations, it must be a primary dealer. This comes with responsibilities, one of which is participation in Treasury auctions. Twenty-one large banks and investment firms are required to bid in the auctions. Additionally, foreign central banks, sovereign wealth funds, or foreign fiscal agents are likely to step in to fill any void left by skittish investors.
Will the Treasury default?
In the narrow sense of the word default, as it applies to the debt issued by the U.S. Treasury, I think the chance of default is pretty close to zero. There is a high likelihood that a deal will be made to suspend the debt ceiling. Even if no deal is struck, the Treasury could engage in asset sales (of gold, student loans, and so on). If the Treasury doesn’t find that sufficient, or desirable, it’s possible that the president could declare a state of emergency and order the Treasury to ignore the debt ceiling. There are lots of scenarios in which I could see the government avoiding defaulting on the nation’s debt.
What about other obligations. Will the government default on those?
Some political promises may be broken or changed. For example, in the case of contractors with the government, the U.S. Code says that if a bill isn’t paid on time, it accrues interest that must be paid by the agency that entered into the contract but the bill does not become an obligation of the U.S. government. So, it could be argued that the default would be by the agency, not the U.S. government as a whole. By the same token, rating agencies may change the U.S. government’s credit rating, but that doesn’t mean the creditworthiness of the U.S. government has changed.
If there is a default, what would it look like?
Default is a worst-case scenario with an incredibly low probability of happening. Worrying about it is like worrying about a meltdown at a nuclear power plant. People do worry about such possibilities—even if they are unlikely to occur—probably because, in part, the results would be colossally bad.
If the Treasury were to default on its debt, I think we would need to look at two different scenarios. The first is a short-term default, to the tune of being late with interest payments by a few days. The second is a scenario wherein the default is long-lasting and perhaps even snowballs.
A short-term default may be already partially priced into fixed-income markets. Treasury bills maturing around the end of October dropped in value to the point where they were trading as though they wouldn’t get paid until the end of November. It doesn’t seem as though a short-term default is really priced into any other assets, though.
We have a historical example of how a short-term default could play out. Treasury bills maturing on April 26, 1979, were defaulted on after a testy debt ceiling battle and when the Treasury’s printers went on the fritz, missing the payment. The Treasury also missed payment on the Treasury bills maturing May 3 and May 10 of that year. The default was temporary, as the investors were eventually paid but without added interest for the delay. Over the ensuing 10 days, the Dow Jones Transportation Index went down 6.0%, the Dow Jones Industrial Average went down 3.2%, and the Dow Jones Utilities Index went down 2.3%. Yields on Treasury bills went up 0.6% (they were yielding around 12.0% at that time due to high inflation), but yields on longer-dated Treasuries and corporate securities didn’t move much. The dollar declined in value a bit, and oil popped up a bit. Globally, interest rates rose, except in the U.K., which probably experienced a bit of a flight-to-safety benefit. All of these effects were pretty short-lived.
Today’s situation is quite different than what it was in 1979, but there may be parallels. We could see a caffeinated version of the 1979 experience in how much Treasuries are used as collateral for financial transactions. Exchanges may require more Treasuries to be posted as collateral, and that could create the perverse effect of increasing demand for Treasuries, driving the yields lower. Or it could lead investors to unwind those leveraged positions, creating some fire sales.
If the default is longer term, it would probably be the fire-sale scenario for financial markets. However, this all assumes that the Fed and global central banks don’t intervene to support markets. In 1979, the Fed didn’t appear to do anything to help the situation. Today, I think the Fed would intervene aggressively, perhaps stepping in to buy as many Treasury bills as anyone wants to sell at high enough prices to keep markets from seizing up. The Fed, after all, has experience in fighting these types of fires.
If there is a deal to lift the debt ceiling, we could see a relief rally in global markets. When it was announced that the Republicans were going to float a deal in front of the president, global equity markets rallied. The best performers were emerging markets and U.S. stocks. Within the U.S., financials, industrials, and consumer discretionary stocks were the top performers. The current fighting in Washington, D.C., is weighing on consumer sentiment, as reflected in the most recent Reuters/University of Michigan Consumer Sentiment Index. A deal could reverse this downdraft, helping consumer sentiment, investor sentiment, and business sentiment.
Are the days of the dollar serving as the reserve currency of the world behind us?
It depends on how things play out. Generally, the bickering about the debt ceiling and threats circulating among politicians and bureaucrats about defaulting on the government’s debt can’t be helping the image of the dollar. It could, long term, shift interest to the British pound or the euro as reserve currencies. The Chinese currency isn’t convertible enough into other currencies to be viable, but that could change over time. A shift away from the dollar as a reserve currency would likely increase borrowing costs for the government and households. It could also lower the value of the dollar, which might be all right for exports but would increase the cost of imports.
In another scenario, this debacle could actually be positive. If policies emerge from this that get rid of the debt limit, ratify that the Treasury will always make paying interest on the debt its top priority, and lead to balanced budgets over the long term, then the U.S. and the dollar could become much stronger as a result of this crisis. I can’t say “If it doesn’t kill you, it makes you stronger” because it might cripple you, unless you take the opportunity to get rid of the possibility of this happening again.
What’s the most likely outcome of this fiasco?
There could be a temporary deal to fund the government and to suspend the debt limit. It may last only to the end of 2013, as Democrats want to modify spending for the 2014 calendar year. So, we may see a clean bill with no strings attached to fund the government and suspend the debt limit, with the provision that a spending committee will be formed. It would be somewhat similar to the agreement reached in August 2011 when the debt ceiling was raised and a deficit reduction committee that the media dubbed the “Super Committee” was formed. We’ll probably see a Super Committee 2.0—or you could call it the Super Duper Committee.
Unless it gets rid of the debt limit, any deal that is crafted will set us up to see a repeat of this crisis at whatever the next deadline is. One side wants revenue, while the other doesn’t. One side wants spending cuts, while the other doesn’t. Like oil and water, these views don’t mix well. Any resolution to today’s problems may just set the stage for the next battle. The big battle is for the 2014 midterm election.