What Happens if US Debt Defaults? Just Short-Term Pain, Sages Say

The stock market and a lot of others at this point aren’t quaking in terror about Washington possibly defaulting on its debt payments. But assuming that failure to meet federal obligations occurs, there’s an argument that the pain would be limited.

That’s provided that the crisis is short-lived. Most market experts have analyses for why this might be so. Others are not as sanguine.

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Cassandras such as the Bipartisan Policy Center warn of “catastrophic consequences for financial markets and Americans throughout the country” if the U.S. government fails to pay interest on Treasury bonds, which are the linchpin of the global economy. A deep recession, jammed-up commerce worldwide, unpaid Social Security recipients—all these horrors could ensue should the government default.

If the U.S. Treasury reaches the X date, estimated for June, when it runs out of patchwork fixes (called “extraordinary measures”) to keep meeting federal obligations, tremendous pressure would weigh on congressional Republicans. They are currently refusing to raise the nation’s debt limit unless federal spending is reduced. Few believe those lawmakers will stick to that goal.

Meanwhile, for asset allocators, whatever is going on in Washington doesn’t merit changes in their allocations. As Matt Clark, state investment officer for the South Dakota Investment Council, puts it, “Uncertainty may increase volatility near-term, but we are long-term investors.”

To many observers, the current situation is reminiscent of the 2011 standoff between a Republican-controlled House and President Barack Obama, a Democrat. Two days before the X date, the sides compromised when the GOP agreed to increase the debt ceiling in exchange for promised future spending trims. The close call did have market repercussions, however.

Back then, the threat of default produced high anxiety in the stock market. Over 10 days, the S&P 500 dropped 15%, according to David Kostin, the chief U.S. equity strategist at Goldman Sachs Research, in a research report. “Of course, there was an almost 25% pullback for stocks of companies with the highest sales exposure to federal spending,” he adds.

Another problem, Kostin says, is that the federal credit rating may be endangered yet again. In the wake of the 2011 crisis, Standard & Poor’s cut the long-term U.S. rating by one notch to AA+, from AAA. Since then, though, that downgrade appears to have no affect on Washington’s ability to borrow.

More recent impasses were resolved without much market impact. In fact, in the four debt-ceiling controversies since, the S&P 500 had a median peak-to-trough drawdown of just 4%.

So what is likely to occur this year?

Everything will be settled without a big problem for investors, predicts Robert Hunkeler, International Paper’s vice president of investments.

“I guess Congress and the White House will eventually finish their game of chicken, and the debt limit will be raised,” he opines. “There might be a little more drama and brinksmanship this time around, because there are more cooks in Congress than usual, and that’s saying a lot. Either way, I wouldn’t change my investments because of it.”

To Kostin and his Goldman staff, the risk that Congress fails to boost the debt limit by the deadline is “higher than at any point since 2011,” but “the team believes it’s more likely that Congress will raise the debt limit before the Treasury is forced to delay scheduled payments.”

If the debt ceiling is not raised in time to make those payments, in Goldman’s estimate, the economy would shrink by about $225 billion per month, or 10% of annualized gross domestic product. That’s provided that the Treasury does what policy wonks call, “prioritize,” meaning somehow continuing to pay interest on the national debt, but to stop payment on other obligations.

For Thomas Swaney, CIO for global fixed income at Northern Trust Asset Management, another credit downgrade for the government is possible.

“The practical implications of a credit downgrade are not entirely clear,” he writes in a report. “But we don’t expect a modest downgrade to result in market disruptions for Treasuries, U.S. agency debt or overnight repurchase agreements.”

To be sure, fixing this crisis still leaves a towering national debt.

“We do have concerns about the long-term impact of excessive debt growth,” says South Dakota’s Clark, “which we believe tends to depress long-term growth and increase risk of inflation, potentially followed by debt liquidation if debt levels pop.”