Overview The rise of Credit Default Swaps indicates an increasing risk of United States Government default. According to the Chicago Federal Reserve, there is a 4% estimated risk of U.S. government default, which would have global ramifications.
Similar to failed banks, the probability of U.S. default is on the rise, leading to a need for reconsideration when allocating capital to treasuries until the debt ceiling issue is resolved.
What is the U.S. Debt Ceiling?
The U.S. debt ceiling represents the limit imposed by Congress on how much the country can borrow.
On June 1, 2023, the debt ceiling is set to expire, and if Congress does not approve raising the borrowing limit, it will result in a U.S. dollar default.
Since the 2000s, U.S. debt has been rapidly increasing due to various factors such as wars in Iraq and Afghanistan, the Great Financial Crisis of 2008, and quantitative easing during the COVID-19 pandemic.
Figure 1: The Congressional Budget Office provides this perspective.
The rising U.S. debt has reached nearly 100% of the GDP, prompting Congress to raise the debt ceiling.
Figure 2: The World Economic Forum’s chart illustrates the rapid increase in debt (red bars) compared to GDP (blue line).
What is the X-date?
As of May 18, 2023, the U.S. treasury had a cash balance of less than $60 billion. This represents the lowest reserve the country has had in over a year. Normally, the balance sheet should be above $150 billion, as suggested by Ben Harris, the former assistant Treasury secretary for economic policy.
Treasury Secretary Janet Yellen has referred to June 1st as the X-date, signifying the day when the U.S. will be unable to meet its financial obligations. The current debt ceiling is set at $31.4 trillion, imposing a legal limit on how much the treasury can borrow.
Why should one care about the U.S. Debt and Deficit Spending?
The answer lies in taxes. The U.S. deficit implies a significant risk of higher taxes, particularly affecting higher income earners such as healthcare workers and physicians on their path to financial independence and retire early (FIRE). The deficit has also contributed to inflation and higher interest rates.
In order to borrow money, the U.S. government has had to increase the money supply, resulting in higher prices. The alternative solution to balance the budget is to reduce spending, which historically has proven difficult and complex. Although it may appear that the government is spending more, it has actually been cutting discretionary expenses as a proportion of total expenditure.
Sixty percent of mandatory spending is allocated to Social Security and other income support programs, while the majority of the remaining funds are allocated to Medicare and Medicaid, the major government health programs.
Due to this constraint, Congress has recently had to approve raising the debt ceiling, causing market volatility and uncertainty as both parties utilize negotiations to advance their partisan agendas.
An important indicator of risk that has recently increased is the price of Credit Default Swaps. We will provide a brief explanation of what they are, why they are relevant, and suggest possible actions for treasury holders.
What is a Credit Default Swap?
A Credit Default Swap (CDS) is essentially an insurance contract for a debt, such as a bond or U.S. Treasury. CDS played a significant role in the banking crisis of 2008, leading to the Great Financial Recession. Banks used CDS to create derivative products and collateralize debts, enabling speculation on mortgage prices through mortgage-backed securities. Companies like American International Group (AIG), Bear Stearns, and Lehman Brothers issued CDS for mortgage-backed securities, which ultimately resulted in their insolvency and the subsequent collapse of banks during the mortgage crisis.
Watch this under 2-minute video for a summary of CDS.
Treasuries and bonds carry the risk of default. A CDS can transfer this risk, whether low or high, to a CDS seller in exchange for a premium. The three parties involved in a CDS are the CDS buyer (bank), the bond issuer (U.S. Government Treasury), and the CDS seller (Hedge Fund). When a U.S. Treasury is up for sale, the interest rate to be paid by the U.S. government at the maturity of the term is implicitly promised to the buyer. Given the potential for default, a CDS can act as insurance against this risk.
Institutions like banks that purchase treasuries and bonds often buy CDS from sellers, typically hedge funds.
Why are CDS Premiums rising?
Recently, CDS prices have been increasing rapidly as the debt ceiling deadline approaches. The debt ceiling has been raised 78 times since 1960, with the most recent increase in December 2021, raising the debt ceiling by $2.5 trillion to $31.381 trillion.
Anticipating another increase in the debt ceiling in early June 2023, the rise in CDS prices has caused concern within the finance community.
This chart displays the interest rate of a 1-month treasury and how rapidly it has risen.
What do rising Credit Default Swap Premiums imply?
The significant increase in CDS prices suggests a higher risk of U.S. default compared to previous periods.
The Chicago Federal Reserve has published a paper analyzing treasury liquidity, the rising premiums of CDS, and their implications. Based on their analysis, the implied risk of default has reached approximately 4% in May 2023.
This data should be a cause for concern. Even if we overcome this current period and raise the debt ceiling, the issue will resurface in 2024.
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What factors should you consider, such as high-yield interest options, selling treasuries, or buying treasuries?
If you have capital invested in treasuries, it is advisable to consider moving those funds to a money market fund or a high-yield bank account like Panacea.
We have also discussed I-bonds, which offer an interest rate of over 4% for the next six months.
Deciding whether to sell treasuries that have not yet matured is challenging. Generally, it may not be worth it, as you might sell them at a loss.
If you are interested in higher yields, purchasing treasuries with a maturity range of 1-6 months at 5.6% could be an attractive option, considering that the likelihood of U.S. default remains low at the time of this writing.
Overall, it is likely that we will navigate through this situation, and Congress will approve raising the debt ceiling. However, it is crucial for our country to address this issue seriously.
We have examined the wavering status of the U.S. as a reserve currency and the necessity for our country to start balancing the budget. Failure to do so will perpetuate this problem, with potentially severe consequences for hard-working individuals who pay taxes and save for the future.