What Happens To Markets If The US Defaults On Its Debt

 
It's looking increasingly likely that Congress plans to resolve the two issues of the government shutdown and the need to raise the debt ceiling together, meaning investors may have to wait a little longer than previously thought for everything to fall into place.

In his latest note — titled "Thinking the unthinkable" — Deutsche Bank global head of FX strategy Bilal Hafeez says that while a technical default on U.S. government bonds resulting from a failure to raise the debt ceiling in a timely manner is an unlikely scenario, it still seems to be garnering the most interest as a topic of discussion with clients.

Hafeez writes:

What would a technical default look like?

Most client interest has centered on the last scenario – a technical default. This is an ultra low delta event, but so highly disruptive that it is forcing all participants to think the unthinkable. The closer we get to this kind of scenario, the more we would expect the world to divide into 1) a flight to safe haven currencies, with JPY, CHF, EUR, and GBP preferred in that order. The sharp divergence in long EUR and short JPY positioning suggests the yen will benefit the most from any position squeeze with a USD/JPY revisit of Y90 not impossible as EUR/USD heads to 1.40; and, 2) an exit out of growth sensitive commodity and most high beta EM currencies. As relatively liquid EM currencies ZAR and TRY would be the most likely to suffer ‘collateral damage’, while proximity will count against the MXN. Note that carry trades were very soft in and out of the August 2011 US ratings downgrade debacle. The only thing going for carry currencies this time around is that exposure as indicated by DBSPI is relatively light.

A technical default would be enormously damaging for the USD’s long-term reserve status, with participants taking a view that if it can happen once, what is to stop it happening again at forthcoming debt ceiling negotiations. The extent to which Treasuries sell-off on a technical default at least relative to other G10 Sovereigns, will be critical in assessing the extent to which US and global monetary conditions are tightening. Presumably the Fed and potentially other Central banks would be drawn into the fray in pursuing additional QE actions, which is partly behind the sharp USD fall-out. Ironically the less disruptive a technical default is, the more it would raise the probability of it happening again, adding to the prospect of more disruptive events in the future.

Of course, this scenario seems the most unlikely at the moment, even if it is perhaps the most interesting to consider.

"More likely when we look back in a month, U.S. short-term rates will have moved up for good reasons — a temporary resolution to the budget/debt crisis, which should lead to a sharp reversal of many of the trades that have worked in the last few days when nervousness on fiscal events have been pervasive," concludes Hafeez.