So far, Democrats and Republicans in the USA have always reached an agreement in good time and raised the debt limit. Confidence that this will also succeed this time is fading. The financial industry plays through crisis scenarios.
Barely a week before a possible US default, Wall Street is gearing up for financial Armageddon. The largest US bank, JP Morgan Chase, has set up a “war room,” according to its boss Jamie Dimon. The bankers have been meeting in this crisis center once a day since last Friday to discuss possible crisis scenarios. If the dispute drags on, the number will be increased to up to three meetings. “We have to be very careful,” he told the finance portal “Bloomberg”. A default could trigger a financial panic.
The White House and opposition Republicans are at odds over the terms of the $31.4 trillion debt ceiling hike. In the US, Parliament decides how much money the state can borrow. The currently applicable limit has already been reached, meaning that the treasury is actually empty. The Ministry of Finance is therefore using so-called “extraordinary measures”, i.e. creative financial tricks, in order to retain financial leeway for as long as possible.
It is unclear how long this will continue. US Treasury Secretary Janet Yellen warns that without raising the debt ceiling, the US government has only until June 1 to pay federal bills. However, it is quite possible that the US government will not run out of money until a little later.
What exactly would happen then is unclear. If the US doesn’t raise the debt ceiling, it won’t be able to borrow money to pay its bills. There is then a lack of money, for example for social programs, pension payments or the salaries of civil servants. It would be a nightmare for the international financial markets if the USA were no longer able to fully meet the obligations from government bonds and these then suddenly lost value.
Banking crisis as a warning
The market for US government bonds has a volume of around $24 trillion, they are the foundation of the global financial system and are often used as collateral for loans, for example. The most recent banking crisis in the USA has shown how important they are. Regional financial institutions had put the lion’s share of customer funds in long-dated US Treasury bonds. When these lost value due to the general rise in interest rates, banks had to lower the value of the bonds on their balance sheets – and thus got into trouble.
In the event of a US default, financial institutions could ask their counterparties to immediately replace the defaulted bonds pledged as collateral. This can create dislocations in the bond market and quickly spread to the derivatives, mortgage and commodities markets.
Because of such risks, raising the debt ceiling was a formality for decades. In recent years, however, the dispute over this has become increasingly relentless. So far, a compromise has always been found in good time. But given the increasing polarization of US politics, it is not a foregone conclusion that agreement will be reached again this time.
The financial markets are still far from panicking. The leading German index, the DAX, is not far from its historical record, which it reached last Friday. The leading US index S&P 500 has gained almost eight percent so far this year.
“Investors are losing patience”
But confidence on the stock exchanges is crumbling in view of the hardened fronts. The DAX lost around two percent of its value this week. “Slowly but surely, investors are losing patience and optimism,” says Konstantin Oldenburger, an analyst at broker CMC Markets.
The financial industry is also becoming increasingly nervous. Citigroup CEO Jane Fraser called the current debt ceiling debate “more disturbing” than previous ones. As Brian Moynihan, Bank of America’s chief executive, puts it: “You hope it doesn’t happen. But hope isn’t a strategy—so you prepare.”
Against this backdrop, insurance premiums against US Treasury defaults are rising. Banks, brokers and trading platforms are arming themselves for possible turbulence and playing through crisis scenarios. They also want to ensure that there is sufficient staff and liquidity and that the technical systems are available to handle high trading volumes.
However, the top priority of the financial industry is to prevent a US bankruptcy by warning of the dangers. This increases the pressure on politicians to find a solution. “I don’t think it’s too [einem Zahlungsausfall] will come. Because that would be catastrophic,” said JP Morgan boss Dimon. “But the closer you get to him, the more panic you get.”