• THE OUTSIDE VIEW
  • A FRESH PERSPECTIVE
  • APRIL 25, 2011

Does the market really believe the US may default?

The US government currently has the highest possible credit rating on its debt; AAA. Technically, a credit rating of AAA corresponds to roughly a 1% chance of default every 15 years. In practice, it means there is no real chance of default. Last week, S&P put the US credit rating on a negative outlook - meaning that there is a possibility they may downgrade this credit rating in the near future. More specifically, there is a 1 in 3 chance that the US credit rating will be downgraded.

Naturally, this news surprised the markets. Stock markets around the globe fell on this news, as one would expect. What was more unexpected was that the US dollar rose on the news, and the price of US government debt was relatively unchanged. Normally, we would expect the currency to fall as well as the price of the debt to fall. This is certainly what has happened with Eurozone countries with their debt problems.

So why did US government bonds not fall on news that the probability of default has increased due to excessive debt levels and persistently high deficits? Why did the US dollar rise instead of fall on this news? The answer is that the markets do not really believe that the US will default on its debt.

In fact, it may even mean the opposite. Often, news of a possible downgrade can encourage politicians to act on the deficit and debt in order to avoid an actual downgrade. Shortly after the S&P came out with its news, US President Obama responded that there was no danger of a downgrade and that Congress would reach a deal on the deficit.

The fact that the stock market fell on the S&P news could be an indication that the market actually expects more action on the deficit. Cuts in government expenditure and increases in taxes will reduce GDP growth in the short term, and hence stock markets would suffer too.

A US default would obviously have very catastrophic consequences. The entire global financial system is heavily reliant on US government debt as the risk free benchmark. Many countries have large holdings of Treasury bonds and certainly don't want to see actual downgrades of US debt.

Given these forces have a strong interest in US debt remaining risk free, it heavily reduces the chance of any default would occur. And this is probably another reason why the market doesn't really believe the US will default on its debt. Of course, markets are not always correct and it remains to be seen what happens in this case.

Disclosure: I do not hold the currency/commodity discussed in this report.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

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