‘It’s not zero.’ Wall Street is pricing in a small but growing risk of a disastrous US default

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230330114512 06 us debt ceiling hp video 'It's not zero.' Wall Street is pricing in a small but growing risk of a disastrous US default

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A US default would have such devastating economic and financial consequences that many observers dismiss the possibility out of hand. But investors are not ruling out such a nightmare scenario.

Even though a default could wipe out millions of jobs and wreak havoc on Wall Street, the White House and Republican leaders in Washington are nowhere near a deal to avert disaster that could strike as soon as July.

As politicians sleepwalk toward a potential debt ceiling crisis, financial markets have begun pricing in a small — but growing — chance of a disastrous default.

The implied probability of a US government default has increased to approximately 2%, according to modeling by research provider MSCI shared exclusively with CNN. That calculation is based on the cost to insure US debt in the market for credit default swaps.

Although the probability of default is tiny, it has increased roughly fivefold since January 2, MSCI said.

Since then, chaos in Congress, underlined by the historic dysfunction leading up to the election of House Speaker Kevin McCarthy, have raised concerns about how lawmakers will reach a compromise on much thornier issues such as the debt ceiling.

“The probability of default has gone up noticeably,” Andy Sparks, head of portfolio management research at MSCI, told CNN in an interview. “It is small, but it’s not zero. And it has gone up in a very significant way.”

An actual default would be terrible — for both Wall Street and Main Street. Moody’s Analytics chief economist Mark Zandi has described a default as “financial Armageddon.”

“I don’t think anyone should be complacent about this,” said Sparks. “Turmoil in the banking system shows how things can change very quickly.”

The federal government hit the $31.4 trillion debt ceiling in January, forcing Treasury Secretary Janet Yellen to take accounting moves known as “extraordinary measures” to avoid default.

Yellen has used unusually strong language for a former central banker to warn Congress against messing with the debt ceiling. On Thursday, Yellen said a breach of the debt ceiling could spark a “prolonged downturn and a global financial crisis.”

“It could upend the lives of millions of Americans and those around the world,” Yellen said in a speech.

Goldman Sachs chief economist Jan Hatzius told CNN in January that even a near-default could cause a recession as well as turmoil in financial markets. Moody’s estimates that even a brief breach of the debt limit would kill almost a million jobs.

All of this explains why many believe Washington will get a deal done before disaster strikes, as it has in the past.

Even though leaders in Washington are not seriously negotiating on a debt ceiling deal, there is still time.

The Congressional Budget Office has estimated that even without addressing the debt ceiling, the government will have enough cash to avoid a default until sometime between July and September. The exact timing for the so-called X-date will depend in large part on 2022 tax collections in April.

Tom Barkin, president of the Federal Reserve Bank of Richmond, told CNN last week that it’s “hard to imagine” the government would breach the debt ceiling.

Still, Barkin conceded if it happened the Fed would be forced to react, much like it did after the Sept. 11 terror attacks.

Others are more pessimistic about the debt ceiling.

Greg Valliere, chief US policy strategist at AGF Investments, only sees a 60% chance that Congress reaches a deal to address the debt ceiling.

“I think we’ll come right up to the precipice,” Valliere, who is based in Washington, told CNN. “Most people in this city feel it’s inconceivable we could default on our debt. I agree it’s unlikely but it’ll be much closer than people thought.”

He pointed to the more radical makeup of the Republican caucus and the reluctance among some lawmakers to vote for a debt ceiling hike.

Even McCarthy, the Republican House Speaker, told CNBC this week there has been “no progress” in negotiations. “Time is ticking. Now I’m very concerned about where we are,” McCarthy said.

“I worry there are just enough House radicals who might not accept anything. And it doesn’t take many of them to make this a crisis,” Valliere said.

Asked about MSCI’s estimate of a 2% implied probability of a default, Valliere said that number is low.

“The markets are too sanguine,” he said. “The market has felt for months that this is like the little boy who cries wolf. But this is not a typical debt ceiling debate.”

There are some early indicators of concern popping up in the bond market.

Morgan Stanley wrote in a report on Thursday that “kinks” have emerged in the Treasury bill market around bonds that mature around the X-date.

“Market attention could swing back to this issue soon” Morgan Stanley advised clients.

Or maybe not.

McCarthy and his top lieutenants say they are prepared to push ahead with a fallback plan: A party-line bill to raise the debt ceiling, CNN’s Manu Raju reports.

But such a move could be risky. Republicans can only afford to lose four of their own members in any party-line vote.

There is also a possibility that Congress punts, reaching a short-term agreement to delay the issue by a few months.

Eurasia Group analyst Jon Lieber said in a report Thursday there is a growing chance that lawmakers put off a debt ceiling solution until the end of the year.

“A short-term punt would merely delay and not eliminate the disruption risks of the debt limit,” Lieber said.

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