Risks around to the economic outlook linked to a looming debt-ceiling crisis have been in the market for some time.
This pricing in of risk has become particularly apparent now that both Treasury Secretary Janet Yellen and the nonpartisan Congressional Budget Office have put Congress on notice that the X-date for default on U.S. debt will be in early June.
Markets are beginning to aggressively price in a potential default. Not only have three- and five-year U.S. credit default swaps soared to multiyear highs, but distortions are also emerging at the front end of the Treasury curve.
From mid-March until April 21, the markets were loading up on one-month Treasury bills. This increased demand for the shortest-dated securities pushed down the rate on one-month Treasury bills to as low as 3.25%, 175 basis points below the overnight federal funds rate.
But after April 21, the market began pricing additional risk into even the shortest securities, with the one-month moving 200 basis points higher to 5.34% as of May 5. The bulk of that increase occurred in just the last few days as the market priced in the increased probability of a near-term default.
We would also note that for the last month, three-month Treasury bills have traded slightly higher than six-month bills, which is not normally expected. That gap widened in the last week, with the three-month now trading at 5.20%, more than 15 basis points higher than six-month rates trading at 5.04%.
That suggests unease over securities maturing in July on speculation of the Treasury’s ability to postpone the default.
Emerging credit crunch
The timing of an economic and financial crisis caused by the political authority could not be any worse.
Recent data points to an emerging credit crunch for both households and firms caused by turmoil among local and regional banks, as well as a pullback in productivity-enhancing fixed business investment.
Upcoming reports like the Federal Reserve’s Senior Loan Officer Opinion Survey, to be released Monday, will most likely confirm a deterioration in credit availability across the economy.
A partial or full default would exacerbate those trends and result in a pullback in spending and investment by households and firms as well as an increase in unemployment. It would almost surely tip the economy into a full-blown recession.
It is likely that an agreement will not be reached over the next four to six weeks, after which it is likely that the government will not have sufficient revenues to meet its debt obligations.
While the political authority prefers to wait until the last second to avoid an economic and financial catastrophe—our base case for this specific crisis—the financial community does not have this luxury.
Market participants can be expected to move further away from riskier assets, a move that over time will result in falling equity prices, rising yields and a falling dollar.
That decline will erode consumer and corporate confidence and alter the path of what to now has been a resilient economy.
The last significant debt ceiling crisis, in 2011, featured a last-second compromise that did not result in a temporary dislocation in asset prices. Instead, it had long-lasting effects that dampened spending, hiring, investment and growth. In the end, in contributed to a far slower recovery from the financial crisis than would have otherwise occurred