Default Fears Start to Shake Investors

Many in the GOP might claim that a short-term default wouldn't have any negative effects, but there are signs that the debt fight has already begun to worry markets.

In a vote that was not close, the House of Representatives rejected a “clean” debt ceiling increase Tuesday night, setting the stage for a summer of frantic debate before the August 2^nd “drop-dead date.”   This sort of wrangling over deficits and the debt ceiling has already begun to worry international bond markets, as evidenced by Standard & Poor's much publicized threat to cut the U.S. credit rating in April.

Nevertheless, some Republicans both in and out of Congress have hewed to the position that a short-term default would not be catastrophic, as long as it is brief and followed quickly by a deficit reduction plan.  Analysts outside the political arena have already debunked this fantasy, but there is reason to worry that even approaching a default could elicit some of the negative effects that would definitely come about if the U.S. were to actually stop paying interest on its debt.

As Steve Bell, the Senior Director on Economic Policy at the Bipartisan Policy Center, has argued on FrumForum, it is important to keep an eye on the spreads for credit default swaps (CDS).  These complicated financial derivatives are essentially default insurance policies for creditors, except that third-party speculators can jump in and bet against the debtor.  The spread is the quarterly premium paid by the buyer of the swap.

With American public debt in the $14 trillion range (a pre-existing condition) and lawmakers engaging in dangerous budget brinksmanship (a smoking habit), insurance premiums are on the rise.  In fact, the spreads for CDS insuring U.S. sovereign debt more than doubled in one day last week, signaling a dramatic loss of investor faith in America’s solvency.

Well, who cares?  This is, after all, the path our Congress has chosen.  Brinksmanship only works when people (in this case, markets) believe you’re crazy enough to blow up the world.  As long as interest rates on U.S. Treasuries, themselves, stay low and Congress does ultimately get America’s fiscal house in order, is it really worrisome that more investors are insuring U.S. debt?

Yes, because the CDS market appears to be where price discovery for credit risk takes place.  So, even though bond purchasers continue to charge the U.S. little to borrow money, CDS spreads reveal the market’s true feelings about the government’s creditworthiness.   At the moment, though, the bond market and the CDS market remain far apart, and, as Eric Burroughs reports for Reuters, real danger doesn’t come until bond pricing catches up to CDS spreads.

So, this raises the question, if CDS spreads continue increasing, how long do we have until the bond markets begin to react?  The answer is unclear.  There are data that suggest a 1% increase in interest rates for every 90-110 basis point rise in CDS spreads, but they are far from conclusive.  Also, spreads for U.S. debt still hover around 50 basis points, so the Treasury would not even see a 1% increase in interest rates until premiums doubled for a second time.

What is certain is that bond markets will not ignore the rising prices of default insurance forever.  If lawmakers continue to play chicken with the debt ceiling and stall on debt reduction to score political points, the U.S. may face rising interest rates and a shortage of lenders even before an actual default.  If Congress continues to threaten disaster, markets may just begin to believe them.

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