What happens to markets if US defaults?

Associated Press

NEW YORK

Time is running out for Washington to raise the country’s borrowing limit and avoid a default. Wall Street isn’t panicking yet. But if the unthinkable happens, a default could strike financial markets like an earthquake.

“If we just get higher longer-term interest rates, we’d be lucky,” said John Briggs, Treasury strategist at the Royal Bank of Scotland.

What might markets look like after a default?

The tremors from even a short-lived default could take unpredictable paths. Stocks, bonds and the dollar would likely plummet in the immediate aftermath.

There’s wide agreement among economists that a default would drive up borrowing costs for everybody. U.S. Treasury yields act like a floor for other lending rates, so raising them makes it more expensive for Americans to take out mortgages, for corporations to finance new spending and for local governments to borrow.

But analysts say predicting exactly how a default would play out in stocks, bonds and currency in the hours and days after the Aug. 2 debt ceiling deadline is practically impossible.

“If I were to draw a flow chart, it becomes so complex it’s impossible to analyze the impact of a default,” said Guy LaBas, chief fixed-income strategist at Janney Montgomery Scott.

When pressed, investors say the immediate aftermath could look like the financial crisis in September 2008. Stocks would lead the way down. In the month after Lehman Brothers’ bankruptcy, for instance, the Standard & Poor’s 500 index lost 28 percent.

Gold may offer some refuge. Fear has driven traders into precious metals in droves in recent years, but gold is at a record $1,594 an ounce, without taking inflation into account. But two places where traders usually hide — the dollar and U.S. Treasurys — are likely to sink as the world’s investors flee the U.S. There would be few places to hide.

A deeper fear is that a default could freeze the short-term lending markets that keep money moving throughout the global financial system. Treasurys and other government-backed debt are widely as used collateral for loans in these markets.

A default and a downgrade of U.S. debt by rating agencies would shake the trust in that collateral, Briggs said. Lenders could respond by demanding borrowers to post more collateral, forcing them to sell other investments to meet those demands. A similar selling cycle spread turmoil across markets when Lehman Brothers collapsed in 2008.

The fallout from a U.S. default could be much worse.

Indeed, most analysts agree that if the world’s largest economy reneges on its debts, the consequences would be catastrophic.