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What impact could the debt ceiling have on financial markets?

The issue of the debt limit becomes more and more imminent as we are getting closer to the deadline that Treasury Secretary, Janet Yellen, gave to political leaders to address the issue. She claimed that the U.S. government may run out of cash and default on its obligations by June 1st if the debt limit isn’t increased. This issue is raising a political crisis that could have important repercussions on the economy, especially on capital markets. If the debt ceiling were to bind, markets would likely whipsaw, potentially enduring immediate and steep losses that might take a while to recover—even if the situation is quickly addressed. Here are some of the key impacts that can occur on capital markets:

1. Increased volatility: The uncertainty surrounding the government's ability to meet its obligations can lead to increased market volatility. Investors may become more cautious and hesitant to make new investments, causing fluctuations in asset prices. 2. Higher borrowing costs: If there are concerns about the government's ability to repay its debts, investors may demand higher yields on government bonds to compensate for the increased risk. This leads to higher borrowing costs for the government, which can have a ripple effect on other borrowing costs throughout the economy, such as mortgage rates and corporate borrowing rates. 3. Reduced investor confidence: A failure to raise the debt limit or a potential default can erode investor confidence in the government's ability to manage its finances effectively. This loss of confidence can spill over into other sectors of the economy, impacting business and consumer sentiment. 4. Weakened US dollar: The US dollar is a global reserve currency, and any doubts about the US government's creditworthiness can lead to a depreciation of the currency. A weaker US dollar can have implications for international trade, inflation, and the cost of imported goods. 5. Market disruptions: In extreme cases where the government defaults on its obligations, it can trigger severe market disruptions. Financial institutions holding government debt may face losses, which can impact their stability and the broader financial system. The resulting shockwaves can reverberate globally, affecting international markets and investor sentiment. 6. Rating agency actions: Rating agencies assess the creditworthiness of governments and issue credit ratings. If a debt limit crisis or default occurs, rating agencies may downgrade the government's credit rating, indicating higher risk. This downgrade can lead to increased borrowing costs not only for the government but also for other entities tied to the government's credit rating.

It is essential to stress that these impacts are, however, hypothetical and depend on the specific circumstances and response of market participants. In practice, when the debt limit is reached, the US government has historically taken measures to avoid default, such as employing extraordinary measures or raising the limit before the deadline. Nonetheless, the mere possibility of reaching the debt limit can introduce uncertainty and create potential disruptions in capital markets.

According to money market experts, even if the Treasury does default, a repeat of the Reserve Primary Fund debacle is extremely unlikely because (1) a U.S. debt default would affect only a small number of Treasury securities, namely those that mature on the date that the Treasury’s cash runs out; (2) the Treasury could shift the impact of running out money by paying off certain bills, such as its bonds, notes, and bills while deferring payments unrelated to securities; (3) many money market mutual funds have had months to pare down their Treasury holdings, replacing them with other high-quality, short-term debt from issuers other than the Treasury.

Money market funds have taken measures to anticipate this potential default. They have been reducing their Treasury holdings by substituting other reliable, short-term debt, and also buying reverse repurchase agreements (repos). Reverse repurchase agreements are contracts with another entity that needs cash for a brief period. The borrower, let’s say the Federal Reserve, pays interest and puts up collateral, such as Treasury bonds with long-term maturities. As a practical matter, none of these will mature around the possible default dates.

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