Markets start pricing an American default

The spread on one-year US sovereign credit default swaps (CDS) rose past 100 basis points in late April. That is the highest level ever recorded, and above the distressed levels of Greece and Mexico. For years the market was treated as an academic backwater, an illiquid corner where a handful of quantitative desks hedged odd structural edge cases. Equity indices sat calmly near their cyclical highs. The derivatives market, meanwhile, had started to price a small but real chance that the United States government commits a technical default on its debt.

The jump in one-year spreads is the work of institutions scrambling for insurance they had never thought to buy. Investors with large holdings of short-dated Treasuries do not believe the US government is insolvent. They are buying protection because they have to hedge the mechanical risk that payments freeze.

How the ceiling was hit

The federal government reached its statutory borrowing limit of $31.4 trillion on 19 January, and the Treasury has been using accounting manoeuvres, known as extraordinary measures, to keep paying its bills ever since. Those measures buy time, not money. The Congressional Budget Office estimated in February that they would run out at some point between July and September, and weaker-than-expected tax receipts this month have led forecasters to worry that the date could come sooner.

The politics have not moved much. President Joe Biden has refused to negotiate over the ceiling itself, and House Republicans unveiled a bill last week that would raise it only in return for spending cuts that the Senate is unlikely to accept. Each side is betting that the other will blink first, which is precisely the situation in which default insurance acquires a price.

What counts as a default

Under the definitions of the International Swaps and Derivatives Association (ISDA), a Failure to Pay credit event is triggered if the Treasury misses a maturing coupon or principal payment and the prescribed grace period runs out.

Suppose political gridlock carries the government past the X-date and Janet Yellen has to halt debt service. Sovereign CDS contracts would then trigger settlement, and protection sellers would owe billions in cash. The market is pricing the odds of an operational breakdown. Nobody is betting on a bankrupt America.

Bills tell the same story

The CDS market is not the only place where the risk shows. Treasury bills that mature around the likely danger dates in early summer have begun to trade at higher yields than bills maturing just before or after, because investors do not want to be holding paper whose repayment might be delayed. Money market funds, which own a large share of all bills, have every reason to avoid those maturities, and their absence as buyers pushes the yields up further.

That kink matters more than the CDS spread in practical terms. Bills are the collateral that underpins the repo market and the cash management of companies and funds across the world, and a bill whose payment date is in doubt is a worse form of cash.

A thin market, loudly priced

The strongest objection to reading much into the CDS spread is that the market is tiny. Relatively little protection on the United States is outstanding, so a handful of buyers can move the price a long way, and a spread of this size says more about demand for a scarce hedge than about any considered probability of default. The spread is also hard to translate into odds, because nobody knows how much a defaulted Treasury would be worth after a brief delay.

All of that is true, and it cuts against treating the number as a forecast. It does not explain why banks and funds are paying for the hedge at all, which is the real signal: institutions that never considered the risk are now required by their own risk managers to price it.

What 2011 showed

The closest precedent is the standoff of 2011. Congress agreed to raise the ceiling on 2 August, the day the Treasury was expected to run out of room, and Standard & Poor's cut America's credit rating from AAA three days later, citing the brinkmanship itself. Shares fell sharply in the weeks that followed, and Treasuries, perversely, rallied as investors sought safety in the very asset that had just been downgraded.

There is also a harder-edged example. In 1979 back-office problems at the Treasury delayed payment on a batch of maturing bills held by small investors. The delay was brief and caused by paperwork, not politics, but economists who later studied the episode found that it pushed up Treasury yields for some time afterwards.

Insurance paid in the same currency

There is an obvious irony here. The contract that hedges a US default is itself denominated in dollars, and it clears through institutions whose own solvency rests on the Treasury market as a benchmark.

If the world's risk-free asset stopped paying, the machinery that clears derivatives would be thrown into legal and operational confusion, and the hedges would be worth rather less than their face value suggests. The signals to watch are the Treasury's daily cash balance, any update from the Treasury secretary on when the money runs out, and the yields on bills maturing in June and July.

A US CDS spread above 100 basis points is a milestone nobody in Washington should be proud of. Even if Congress settles the debt ceiling at the last minute, investors have now put a price on an American default, and the dollar's reserve-currency premium will be a little thinner for it.