Thinking the Unthinkable: Stress-Testing a U.S. Treasury Technical Default
June 08, 2023
By Matthew Lightwood, Ph.D
The Congressional Budget Office and the U.S. Department of the Treasury projected that the United States government would no longer be able to pay its bills on June 5th, 2023, a date often referred to as the “X-date.” This scenario was narrowly avoided with an agreement reached and passed into law on June 2nd, but had these talks failed and the United States slipped into technical default,1 we could have reasonably expected a financial market crisis equal to or exceeding the 2008 crisis triggered by the collapse of Lehman Brothers. Given that the current agreement is only likely to cover debt requirements out to 2025, it is perhaps prudent for insurers to add a U.S. Treasury technical default scenario to their existing stress-testing framework.
But what impact might such a scenario have on financial markets? In this short article we discuss the likely effects of a technical default of Treasuries and introduce two possible scenarios for how the crisis might play out. These two scenarios could be used as a basis for current or future scenario analysis.
What Would Happen If the Debt Ceiling Were Breached?
With increasing political divisions within the U.S., the likelihood of a default scenario is perhaps higher now than at any other time in recent history. Given how close to the X-date agreement is often reached and the frequency with which the debt ceiling must be raised, it is a highly plausible scenario that the U.S. at some point in the future fails to meet its obligations to bond holders, either accidentally (e.g., from overestimating the X-date) or by political intransigence.
There is no historical precedent for such an event, but while the effects are perhaps difficult to predict, any default scenario, even if it was technical in the sense of a delay of several days in paying obligations, is likely to be accompanied by large equity drawdowns, increased yields and borrowing costs, higher unemployment, and shocks to credit spreads on corporate bonds. The effect on households and the real economy would be cataclysmic in the short and medium term, perhaps like no other crisis we have known. With few fiscal or monetary options to buffer households from the worst of the storm, the crisis would have to be solved at the negotiating table. By then the damage would be done, however, and the effect of the crisis compounded with the panoply of recent crises could take many years to recover from.
In this article, we consider two possible scenarios for the aftermath of a default: a brief and transitory default and a protracted default. These are discussed further in the sections below, and scenarios for the United States economy are proposed which could be used for stress-testing and scenario analysis.
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1 In the case of most Sovereign debt defaults, including the type discussed here, payments are usually either delayed until tax revenues are collected or the bonds are restructured in some way, for instance by lengthening the term of the bond. For this reason we talk here about the default as being technical rather than a debt services default in which the issuer is (usually) insolvent.
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