June 9, 2023


Complete News World

Bondholders hold their breath before the debt ceiling deadline: – Pricing under the ultimate risk of default

After the unresolved week on the US debt ceiling passed, tension began creeping closer and closer to investors before trading opened again on Monday morning.

In the market, the prices of default swaps (CDS), which are instruments that allow investors to insure government bonds against default, have been rising lately. CDS now cost more in the US than countries like Greece and Brazil, a clear sign of the fear that gripped the market.

The bond market is definitely worried. Credit default swaps have not traded at such high rates for at least 15 years. From this it is clear that the bond market is priced under the ultimate risk of default, says Alexander Miller, chief investment officer at Odin Forvaltning.

The consequences are dire

The debt ceiling was already reached in January, but the US has covered the current debt expenditure by bringing in money from other items. However, within not so many working days, the coffers run out and then additional loans must be obtained to service the debt already incurred by the state.

The United States had never defaulted on its debt before, although it was a long way off in 2011. Then the parties agreed to raise the debt ceiling just two days before the deadline. The result was a downgrade of US government debt from A to double A, while there was also a notable drop in the stock market for the broad S&P 500 index.

See also  Investor Peter Hermannrod believes globalization is a 'reality' - and thinks it will hit the corona winner harder: - There it can go from heaven to hell

Ahead of the weekend, the US Treasury said that as of May 10, it had “only” $88 billion to use in exceptional circumstances.

If June 1 passes without an agreement between Democrats and Republicans, it will mean a technical default on the US national debt. This means, among other things, that the owners of most short-term government bonds will risk not being paid.

– You can’t imagine anything unimaginable. We have too little experience to predict the impact of such a situation. If that happens, the consequences will be dire in terms of the cascading effects it would have for all dollar-centric and dollar-dominated markets worldwide, Olaf Chen, head of global allocation and interest at Storebrand Asset Management, tells DN.

The dollar is considered the safest currency in the world. If the US defaults on its national debt, it could weaken the dollar’s status as a reserve currency in the long term, but in the short term, the dollar may continue to strengthen, as it often does in times of great uncertainty, Chen believes.

– There is still a big scratch in the paint if there is a default, as the dollar can no longer be considered the safest thing. There is also some doubt as to whether it can be used as a guarantee always and in all cases without risk.

on your toes

Thus, the market is on tiptoe when President Joe Biden and his cabinet hold meetings with Republicans next week. There was talk of finding a long-term solution rather than a short-term clarification which would mean the debt ceiling would be approached again after the summer. Republicans have indicated that they want a sharp cut in government spending to agree to raise the debt ceiling.

With US government bonds’ reputation as one of the safest things to invest in, any data on the debt ceiling in the coming weeks will be scrutinized.

Treasury Secretary Janet Yellen warned earlier this week of the consequences if the debt ceiling is not raised.

– If Congress does not find a solution, it will affect our credit rating. Something will falter if the debt ceiling isn’t raised, whether it’s government bonds or Social Security recipients. She said this had not happened in the United States since 1789.

No fear of being tracked in the stock market

Wherever fear has grown in the bond market, interest rates and equity markets seem unfazed by the fact that the deadline is fast approaching. For the major indices on Wall Street, there were little changes from day to day throughout the week, while in the interest rate market, the two-year and ten-year interest rates are somewhat below levels at the start of the month.

It is currently unknown exactly how a technical default on US government debt will affect the markets, but for the time being investors don’t seem to be overly concerned. The VIX, or fear index as it is often called, has seen a downward trend in recent weeks.

– The stock market seems a little too worried. Even the part of the stock market that relies on government funding has done as little as the rest of the market, says Miller.

He believes that it is not easy to determine why the stock market and the bond market would react so differently to a potential default.

Chen explains the stock market’s unwavering calm with what he refers to as apparent “tail risk.”

– It is something that can happen with very little probability, but if it does, the consequences are severe. The fact that the stock market has not yet started pricing in default risk is because you feel like you still have a lot of time. One thinks that it will work out in the end and that this is just a political game again.

(conditions)Copyright Dagens Næringsliv AS and/or our suppliers. We’d like you to share our statuses using links that lead directly to our pages. Reproduction or other use of all or part of the Content may be made only with written permission or as permitted by law. For more terms see here.