USA (Aaa/AA+) Debt Ceiling Crisis, 2023 Edition
Washington, we have a problem
The market for credit default swaps on the United States of America is relatively small at $12 billion (notional), versus $23 trillion of US Treasuries outstanding. The probability of a US default is non-zero. The US default probability is the highest ever at 2.8%, as per Bloomberg. Moody’s cumulative, 5 year default probability for a Aaa credit is 0.10%. This is not an event easily modelled with traditional VaR based models.
The standard contract term for the CDS market is 5 years, but other maturities also trade. As of Friday May 12, 2023 USA 5 year CDS was offered at 69 basis points (0.69% in per annum premium), a record high. As a frame of reference, 5 year CDS for the US entered 2023 at 24 bps (0.24%). China, which is rated A+ CDS is at 74 (0.74%) in 5 years.
The current 10 year UST (on the run) has a coupon of 3.375% and a maturity date of May 15, 2033. A portfolio manager looking to hedge against default by the USA would pay 69bp per annum (i.e. $69,000 per 10 million notional, a typical transaction size), 20% of their running yield to protect against the default of a Aaa/AA- credit that administers the world’s reserve currency. Another reason the US sovereign CDS market is small, it that players are uncertain of the mechanics of settlement. In a typical CDS contract, an auction is held to determine the recovery rate. Post default, upon settlement, the hedger (long US CDS cover) delivers a qualifying US Treasury security (cheapest-to-deliver under a “borrowed money” definition would be the lowest coupon long bond which has a maturity of 30 years) and receives par. Upon default all US Treasury securities would trade at the same price (the recovery rate). Some hedge funds are building inventory in the cheapest-to-deliver long bonds in the $60’s (in price terms). Depending on the aggregate size of this arbitrage attempt (assume billions), there could be turmoil as the crisis hits peak in the coming weeks. CDS only “pays out” upon a default, but clearly some speculators are trying to play the spread migration to wider levels.
Due to the impending debt limit crisis, the US CDS curve is inverted. Risk is elevated in the short end. 1 year US CDS is wrapped around 176 (1.76%). That is 107bp (1.07%) of inversion 1-5’s! Brazil 5 year CDS is at 57, Greece 49 and BBB-rated Mexico 37! Crazy pills.
Before the 2007 GFC the CDS market for the AAA-rated contiguous US states (GO - general obligation bonds) was 10bp (0.10% per annum). At the worst of it, California CDS trades at 470bp (4.70%). According to the Depository Trust & Clearing Corporation (DTCC), as of September 2021, the total notional outstanding amount of Municipal Credit Default Swaps (CDS) was approximately $86 billion, 7x the USA sovereign CDS notional outstanding.
In terms of mechanics, a hedger or speculator (more likely) counterparty enters into CDS contract with a Bank counterparty. The arrangement is documented under an ISDA (International Swap Dealers Association) in concert with a CSA (Credit Support Annex) to manage counterparty risk. With hedge fund counterparties the threshold is typically set at $0 (2-way) meaning that collateral will be posted by the cpty with a negative mark-to-market (mtm). In a typical CSA schedule cash is given 100% value and other instrument have a haircut (i.e. 2 year UST 98%) with a bigger haircut for longer dated instruments (given the high interest rate risk).
The US has not run a surplus since the year 2000, as per the chart above. Democrat or Republican, it matter not. The forecasted deficit for 2023 is -1.94tln versus record tax receipts of $6tln +. The US fiscal situation is worsening. S&P cut the AAA rating of the USA in August 2011 to AA+ (negative watch). Moody’s remains at Aaa, as does Fitch who rate the US AAA. The United States is “split-rated” as a result. Likely resolved by Fitch next taking the US into the AA’s, in my view.
The current US debt ceiling is US$31.4 trillion. Current US debt stands at $31.7 trillion
The US Treasury had $143 billion in cash/near-cash to end the week, down 11.5bln on the day (debt service is $2bln/week now). The Treasury has enough cash to continue servicing their debt, for a short period of time (est. 1 quarter), but the question raised is what payments cease? For reference. Warren Buffett’s Berkshire Hathaway has $130bln in cash and with investable short end fixed income yielding >5%. Warren likes cash more than stock presently.
The equity market in the US will eventually react forcefully as this plays out. Risk assets will be sold and many will revisit circuit breaker levels in a market that has traded inside of a 1% range for 6 weeks. -10% over a few trading days will get the spotlight on the debt ceiling issue. Such a move would have the S&P at -3% for 2023, hardly an extreme call. There have been other instances where the US has faced the threat of default, such as during the debt ceiling crisis of 2011. During that time, the stock market experienced significant volatility, with the S&P 500 index falling by 17% from its high in April to its low in October of 2011.Many want to be more like Warren Buffett, and if many attempt a tactical asset allocation shift from risk assets to money market the market could fall precipitously. Equity market breadth has been horrendous, as has volume. 10 names in the S&P account for all the 8% upside year-to-date in 2023, the top 5 names are up 58% from their 2022 lows. Apple’s $2.7 trillion dollar market cap now exceeds the market cap of the Russell 2000.
US Debt ceiling negotiations:
Talks between Biden and Kevin McCarthy have not yet started. They are planned for this week before Biden heads to Japan. Key entitlement programs are off the table for cuts, as agreed by both sides, namely medicare and social security. Military spending is not going down with the Ukraine war in year 2. Interest expense is up markedly from 2022. Find me billions in cuts. The Republican want $5 trillion in spending cuts over the next 10 years (-14% in spending, by a government). There is no precedent for this ask. Higher CDS levels ahead, can 5 year break 100? McCarthy took 15 tries to become Speaker of the House. IF we get a debt ceiling deal we will likely need a new speaker.
A debt ceiling resolution is likely, as the debt ceiling issue has always been resolved in the past. The United States has a long history of meeting its debt obligations, and defaulting on its debt would have severe consequences for the country's financial standing and global economic stability. The U.S. government has never defaulted on its debt. A short term “patch” extending the debt limit for a shorter time frame, with a $1.5tln bump in size, is a likely outcome (6 months of oxygen). That takes into the crash prone late fall months. The markets would clearly like to see the debt ceiling issue resolved, full stop. Resolution may prove elusive, as the required cuts in spending (entitlement programs) are just too hard ahead of a 2024 election. The Democrats are offering a thimble full of blood (i.e. Funds from the 2021 stimulus not get distributed, est. $30-50bln) whereas Republicans want an arm (trillions).
A technical default would lead to global mayhem.
Disclosure: I’m short the S&P via ES futures (aka, talking my own book).
Caleb Gibbons, CFA