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  • Writer's pictureIshfaaq Peerally

Will the US Default on its Debt?

US Secretary of the Treasury Janet Yellen warned yesterday that the Treasury will run out of cash by the 18th of October 2021 if the debt ceiling is not raised or suspended and that the US will have to default on its debt, leading to a recession and a financial crisis. The markets did not like this with the S&P 500 $SPX500 falling by more than 2% and the Nasdaq $NSDQ100 by more than 2.8%. Will the US Default on its debt and what will be the consequences?

The US Government has been running a budget deficit for decades and with low-interest rates, they have been taking more debt to run this deficit. This becomes an issue when the government cannot borrow money because of the Debt Ceiling. According to the US Constitution, Congress has to approve any debt that the Treasury will issue, that's why the Debt Ceiling exists.

Failure of Congress to approve expenditures can lead to a Government Shutdown (which is not really such a big deal) but if this persists for long enough, the Treasury will run out of cash to repay its debt and will default. This is the situation we are in today. We may have a Government Shutdown by end of September and the Treasury will run out of cash on the 18th of October 2021.

A similar situation was avoided in 2011 and 2013 and the S&P demoted the US Government debt from AAA to AA+. The market did not like it.

If the Government defaults, what the Treasury will initially do is to defer the maturity of the debt. For example, bonds maturing on October 18th will be changed to October 19th. This is what is expected looking at the spread between short-term bonds maturing in October vs those maturing in December. Therefore, investors expect that eventually a compromise will be found and all debt will be repaid. $TLT

If a compromise is not found, the Federal Reserve System might intervene. For example, The Treasury can issue a Trillion Dollar Coin and deposit it with the Fed, which will then print money to give to the Treasury. There are other options.

It is possible that the US Government will default but it is unlikely that it will lead to a financial crisis if the Fed interevenes. Of course, this could lead to other problems such as inflation $GOLD .

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