Default Threat Speculation: Wall Street Wakes Up To Default Threat On Debt

It has been months since Wall Street speculated about the government defaulting on its debt. Slowly now all are eyes are on it as the date to raise the nation's $31.4 trillion debt ceiling looms with no deal in sight, draws near, a per a POLITICO news report.

The traders and executives are at tenterhooks for they feel that President Joe Biden and Republicans won't resolve the impasse until it's too late. It has sparked increasing concern about a potential threat that could rock markets and tilt the world's largest economy into recession.

Chief political economist at Goldman Sachs, Alec Phillips, said, "there is this view in D.C. that the market isn't freaking out enough, and that may be true to an extent. But I've been dealing almost exclusively with this issue the last few weeks, and there is actually more concern now than even in 2011," when Standard & Poor's downgraded U.S. debt during a similar standoff. "It's just that nobody knows when it's going to happen or what to do about it."

The reaction of Wall Street investors is crucial to note because they're the ones who finance the country's enormous debt by buying the securities that Treasury sells to fund the government. If they shy away from the market, interest rates could skyrocket, squeezing the government, businesses and consumers. Therefore, their level of confidence would serve as the strongest force to drive Washington partisans to make a deal.

Many Wall Streeters for most part of the year assumed that having learnt a lesson from the 2011 crisis that the government would prevent such an event from happening again. That faith is starting to fade amongst masses, including voters who were furious over declines in their retirement accounts as stocks plunged.

"Debt ceiling negotiations are essentially nowhere," Brian Gardner, chief Washington policy strategist at investment bank Stifel, wrote in a note to clients. Gardner added that while a last-minute deal could certainly emerge, "the GOP's narrow majority and the Speaker's tenuous political position make the pathway to an agreement more uncertain than usual."

It is noted that yet the situation is not as panic-stricken, the government has until the summer to strike a deal. The Treasury Department likely to run out of room to keep paying the nation's bills and servicing its existing debt is far-fetched for now.

But signs of stress are piling up, especially after House Speaker Kevin McCarthy came to the New York Stock Exchange on April 17. He came up with the GOP case that any hike in the borrowing limit must come with significant spending cuts. That's something the White House and congressional Democrats aren't considering.

The shift from general nonchalance to rising concern can be seen in an obscure corner of the markets: the soaring cost of insuring against exposure to U.S. debt through instruments called credit default swaps, which mitigate risk for large holders of Treasury securities.

The cost of insuring against a U.S. default rose to its highest level in over a decade on Thursday. As JPMorgan analysts said there was a "non-trivial risk" of at least a technical default on the government's debt. The nation would run out of borrowing ability for even a short period before a deal is reached.

Darrell Cronk, chief investment officer of Wells Fargo's wealth and investment management division, said his biggest concern is that the "X-Date" - the moment when emergency moves to forestall default are exhausted - it gets postponed to early-to-mid June with 2022 tax receipts likely weak after a brutal year for markets.

Goldman Sachs researchers said they also expect a much shorter timeline due to a steep reduction in capital gains revenue. Also, McCarthy's hardline position - as well as questions about whether he can unify House Republicans over any strategy at all - have raised alarms. "People seem to be dug in a little bit more in the trenches," Cronk said.

However, some bank executives said they are growing more concerned about the state of play in Washington but remain unsure how to inject themselves into the debate. Speaking out would unlikely spark fears swaying hard-line conservatives, given that such calls would probably be dismissed as special pleading by rich Wall Streeters.

As per the report, now, most of them are issuing anodyne statements arguing for the importance of not allowing the U.S. to default, in a bid to nudge the two sides toward a solution.

Post McCarthy's address, congressional Republicans urged bankers to press Biden to engage with the GOP.

"Obviously, Wall Street people are worried," Sen. J.D. Vance of Ohio said in an interview. "We'll just say, 'Look, it's a two-party system. And Kevin McCarthy gets to make the first shot across the bow, but they need to put pressure on Joe Biden, to the extent they're able to, to actually come to the negotiating table."

Rep. Warren Davidson of Ohio said he's telling bankers that "the only way that we're going to not default later is if we start taking corrective action now."

"Joe Biden's plan is to not take corrective action now," said Davidson, a member of the House Freedom Caucus. "That's a nonstarter. We're not going to move his 'no action now' bill," he said, referring to Democrats' hopes of passing a "clean" debt limit hike with no spending cuts.

While Democrats expressed their frustration that the financial world hasn't exerted more pressure on Republicans.

"Wall Street and business need to start getting energized and put pressure on Republicans to do what we've done all these years, which is pay for the debt that we incurred and not hold the American people hostage," said Rep. Pramila Jayapal of Washington, who chairs the Congressional Progressive Caucus.

Senate Banking Chair Sherrod Brown (D-Ohio) said he was confident Wall Street would eventually speak up. "But I think that it's telling that McCarthy went to Wall Street to talk about all this because he's Wall Street's guy," Brown added. "So we'll see."

Meanwhile, concerns over the impact that a nasty fight over the debt limit could have on the economy are showing up on bank earnings calls.

Goldman CEO David Solomon identified uncertainty over the debt limit as a potential source of volatility during the bank's call on Tuesday.

An hour earlier, responding to a question from POLITICO, Bank of America CFO Alastair Borthwick told reporters he didn't have much to say on the status of non-existent negotiations between the White House and McCarthy.

"Obviously, we're all hoping that gets resolved successfully," he added.

Citi CEO Jane Fraser said her bank believes it's "now more likely that the U.S. will enter into a shallow recession" later this year. "The biggest unknown," she told analysts on the bank's recent earnings call, is "how the debt ceiling plays out."

BlackRock Vice Chair Philipp Hildebrand warned at the Bloomberg New Economy Gateway Europe Forum on Thursday that default would undermine "a basic anchor" of the world's financial system and "must not happen."

"All we can do is to pray that everyone in the United States understands how important the sanctity of the sovereign signature of the leading currency, of the leading bond market, of the leading economy in the world is," Hildebrand said.