Measuring the risk of default in the debt ceiling crisis
REAL ECONOMY BLOG | January 27, 2023
Authored by RSM US LLP
The standoff over raising the federal government’s debt ceiling is not the first time that members of Congress have threatened to default on payments of existing U.S. public debt.
During past episodes, the policy brinksmanship has pushed up the cost of financing, caused a selloff in equity markets and led to a general decline in corporate and public confidence.
Both the public and financial markets tend to approach potential debt ceiling crises with a certain amount of skepticism and fear. One cannot simply ignore the current debt ceiling debate as talk or the price of negation.
While one should tread gingerly when attempting to extrapolate political rhetoric onto a likely response through financial markets, there is now evidence that this political discord is raising the cost of issuing public debt and increasing financial stress.
In our estimation, it will be some time—we think between August and October—before the U.S. government reaches a date that risks default. But there are already signs that the political polarization is resulting in financial stress.
Consider the one- and three-year U.S. credit default swaps, which have already spiked above levels of previous financial and political crises.
The CDS market is a vehicle for passing the increased risk of corporate default onto another party more willing to take on that risk.
For instance, a business lender might consider that the interest rate on existing holdings is no longer adequate compensation for the increased risk of an economic slowdown and the increased risk of default by corporate borrowers. The CDS market offers additional insurance for that risk.
Now, the cost of a one-year CDS is substantially higher than a three-year contract, implying a greater risk of default within the next year than in the next three years. Note, however, that the risk of further disruptions within the current term of Congress remains elevated.
This is not the first time for such an increase. The spike in the cost of protection offered by the CDS market in these recurring episodes is an indication of the effect of political discourse on the economy.
Just the threat of a U.S. default will have an impact on financial conditions and financial stability, which diminishes the ability of the business sector to borrow and lend, and will disrupt the normal course of the business cycle.
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This article was written by Joseph Brusuelas and originally appeared on 2023-01-27.
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