What a U.S. Debt Default Means for the Nation

Not only does the deeply-divided U.S. Congress need to agree upon a resolution to the partial government shutdown, now on day three, but it’s also butting up against a deadline, that if breached, the Treasury Department calls “catastrophic:” Here’s a look at what even the threat of a debt default could mean for the U.S. economy.

1. U.S. Financial Markets

In 2011, when the nation was in the throes of yet another fiscal conundrum about whether to raise the debt ceiling or slash government spending, all of the uncertainty from lawmakers out of Washington roiled the nation’s financial markets. On the heels of a Standard and Poor’s credit downgrade of the U.S. from a sterling AAA to AA+, the Dow Jones Industrial Average plunged more than 600 points in just one session, and fears of an actual debt default coursed through the veins of global financial markets. Analysts at Bank of America Merrill Lynch estimate U.S. equities shed some 19% during the deeply uncertain time period. As the deadline for a debt ceiling increase nears, markets participants and analysts grow increasingly concerned about the potential of a debt default this time around. Todd Schoenberger, managing partner at LandColt Capital, said the tone on the floor of the New York Stock Exchange is grim as traders try to parse statements from government agencies and lawmakers in Washington for clues about what might happen in the coming weeks. “Traders are anticipating the floor giving out.  The (Affordable Care Act) issues...the shutdown...the finger pointing.  Traders are hearing from their investors and it's an uneasy feeling.  Many are having flashbacks from 2008.  I'm serious about this: We are anticipating a life changing moment for the household balance sheet,” he said. In a note to clients, Bank of America Merrill Lynch warned even if the debt ceiling is raised, and the nation does not begin to default before the drop-dead date of Oct. 17 given by Treasury, there’s still a great risk for credit downgrades. “Moody’s and S&P would likely remain unchanged. Depending on how contentious the negotiations are, there is an increasing probability that Fitch downgrades the rating from AAA to AA as the ‘X’ date is approached,” the bank wrote. In the event of a debt ceiling breach and default, Merrill said it expects S&P to quickly move the rating to “selective default,” while Moody’s and Fitch would likely kick the rating down one notch to “restrictive default.”

2. U.S. Economy

The financial markets are just one slice of the economic pie – if a debt default should happen thanks to growing disagreement in Washington, there are severe consequences for the U.S. economy as a whole as well. The Treasury Department said on Thursday the U.S. economy could plunge into the worst spiral since the Great Depression in the event of a default.

Goldman Sachs noted on Wednesday there’s growing concern over the Treasury bond market that is sure to take a big hit in the event of a default.

“Starting with the (Treasury) bill maturing on October 17―the day the Treasury Department has suggested it would exhaust its borrowing authority―bill rates are elevated, suggesting lower investor appetite for holding these securities,” the investment bank wrote in a note to clients. “The distortion in the bill curve is most apparent in the security maturing on October 31, just after Treasury is likely to have depleted its cash balance. This unusual ‘humped’ pattern is similar to that seen in late July 2011 during the last debt ceiling standoff.”

Still worse, it could be that the closer the nation inches to the deadline, the damage could already be done to financial markets and the economy even by the threat of default. Schoenberger said just the bluster in Washington over whether to raise the borrowing limit would be enough to cause Wall Street to lose all of its heft yearly gains (the S&P 500 is up almost 19% on a year-to-date basis).

“The president himself said yesterday, ‘Wall Street should be worried,’” he said. “Can you imagine what Obama and Congressional leaders will be saying leading up to a doomsday default deadline of October 17th?!  That kind of negative, end-of-world rhetoric will be the catalyst to bring the bears out of hibernation.”

3. Global Economies

Washington gridlock has the potential to cause harm to more than just the U.S. economy. On Thursday, the International Monetary Fund’s chief, Christine Lagarde, noted the uncertainty and potential for default could reach to the global economy as well, calling a solution to the impasse “mission critical.”

Lagarde also said Federal Reserve’s announcement it would may scale back its massive $85 billion per month bond-buying program had already had an impact on emerging markets, but a default on U.S. debt could shave off 0.5 to 1 percentage point off GDP in major emerging markets.

The Bank of Japan said Friday it was also growing increasingly concerned about the budget and debt standoff, saying it would increase its stimulus program should the situation in the U.S. grow more deeply divided and uncertain.

The central bank's governor Haruhiko Kuroda told reporters after a two-day policy review meeting the consequences of a prolonged stalemate would be "severe" for global markets and the world’s third-largest economy.

"If this continues for a long time, this could destabilize financial markets and worsen sentiment," Kuroda said. "We sincerely hope a solution is reached at an early date."

4. Household Wealth and Private Sector Confidence

The impact won't just be for Wall Street traders. Mom and Dad could see the values of their 401(k)s plunge as well.

“Wealth is an important determinant of household consumption spending, and consumption spending accounts for about 70% of GDP. From the second to the third quarter of 2011, household consumption fell $2.4 trillion,” Treasury outlined.

Even the threat of a default sparked a 19% plunge in U.S. equities in 2011, according to calculations by BofA, which signals caution ahead for household wealth.

“Recall that the big sell-off around the last debt ceiling came several days after the agreement was signed when S&P downgraded the US debt, triggering a 6.7% one-day stock sell-off. Over the entire debt limit debacle in 2011, equity markets dropped 19%,” the bank wrote.

Additionally, Treasury warned of a drop confidence as a result of the discussion surrounding debt-ceiling talk.

“Consumer and business confidence were falling in 2011, and as the debate about the debt limit progressed, business and household confidence fell to levels that are typically only seen during recessions. It took months before confidence recovered, even though, ultimately, there was no default,” the department said.

5. Mortgage Rates

Over the last couple of months, the U.S. housing market has shown signs of improvement – a bright spot in an otherwise bleak economy. However, combined with tighter financial conditions which could cause the Federal Reserve to delay tapering its massive bond-buying program, the debt ceiling debate could have a big impact on the still-recovering housing market, according to Merrill.

It’s not clear that the impact will be all bad, however, with the specter of a default potentially pushing Treasury rates, and potentially mortgage rates, lower as traders bid-up the safe-haven assets.

“The potential for a messy debt ceiling debate could also lead to lower rates than we expect. While we do not expect Congress to allow the government to go beyond the so-called drop dead date in mid-October, even an approach to that date could hurt confidence and lead to a rally in Treasury rates,” Merrill wrote in a note to clients.