An impasse between the US Senate and Congress on raising the debt ceiling could potentially be catastrophic: credit markets could freeze, the value of the dollar could plummet, US interest rates could rocket, and the negative spillovers could reverberate around the world.
This could precipitate a financial crisis and recession more severe even than the Great Depression.
As one Wall Street analyst has said, it would be like "preparing for a large asteroid impact".
It is this scenario that is leading to much anxiety among investors around the globe.
Despite the grim possibilities, our base case view is that some form of agreement will be reached. This could be in the form of a short-term agreement that provides funding for only a few months, or a more comprehensive agreement that would fund the US government for the entire fiscal year, while also raising the debt ceiling. The latter outcome as it would bring certainty back to markets.
The consequences of not reaching an agreement could be devastating for the global economy with the exact outcomes unknown, since the US would be sailing in uncharted waters.
These consequences could include:
l A collapse in the US dollar and a surge in treasury yields that would destabilise the global financial system as we know it. Since all markets price off the US yield curve, interest rates around the globe would rise, choking off the current weak economic recovery.
l The US would lose its status as a reserve currency country, prompting a move towards a partial gold standard. With China possibly five years away from itself becoming a reserve currency country, it has been aggressively accumulating gold reserves.
l Social security, medical aid payments to suppliers and war veterans' salaries would all come to an abrupt halt, with the loss of consumption expenditure severely impacting on economic growth.
l Collateral markets would go into a tailspin as US treasuries would no longer be considered as adequate collateral against loans. Companies would have to find other instruments to use as collateral.
This could have huge consequences for not only the credit markets but also derivative markets, the costs of which are probably incalculable.
The yen, euro and pound would appreciate strongly on safe-haven demand, effectively eroding their countries' export competitiveness.
With the risk of deflation extremely elevated, the world could find itself in a 1930s-style depression.
l Countries like China and Japan would realise huge losses on their treasury holdings which, apart from destabilising their own economies, would destroy international relations between them and the US, signalling the demise of the US as the world's dominating superpower.
The potential for regional conflicts would no doubt increase the risk of full-blown wars.
l Commodity-producing countries would be vulnerable to sharp declines in commodity prices, with the possible exception of gold, while countries with high current account and fiscal deficits would be severely punished.
l Against this backdrop, risky assets would sell off sharply, prompting negative wealth effects, the magnitude of which would deepen the economic depression.
l Although this is not the first time the US government has been shut down, it would be the first time the US has ever defaulted on meeting its debt obligations.
The government has shut down 17 times, the last event taking place in 1995 and 1996. In each instance, however, the opposing sides eventually reached some form of compromise agreement.
l In the light of the sheer magnitude of the potential fallout from a debt default, our base case view remains that the debt ceiling will be resolved.
We believe that despite the political posturing taking place, politicians' self-preservation instincts and the fear of an unprecedented backlash from the electorate should the US default will ultimately ensure an agreement.
l David Galloway is a strategist at Sanlam Multi Manager International.
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Original headline: Fear of backlash could spur US deal
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