US debt default
With interest rate updates a week away for both countries, the immediate concern for investors is the fast-approaching deadline for lifting the US debt ceiling. The US government’s debt ceiling currently stands at over US$ 31.4 trillion but risks running out of cash. That is something the US has not done since 1789. US Treasury Secretary Janet Yellen stated the government could run out of cash to cover its expenses as soon as June 1.
If the US were to default on its debt payments, it means that the US government is unable to pay back the money it borrowed from people, organizations, and other countries. This borrowed money is represented by US Treasury bonds, which are like IOUs or promises to repay the borrowed amount with interest.
If America were to default on these payments, it would have serious consequences for everyone. No one is quite sure what those consequences would be since this has never happened before. US Federal Reserve (Fed) Chairman Jerome Powell warned that not raising the debt limit would be unprecedented, with highly uncertain and negative effects on the American economy, as well as the global economy. Many financial experts are sure a default would be extremely damaging, depending on how long the US would remain in default. Here are a few examples of what could happen:
- Financial Market Problems: A US default would create a lot of uncertainty and worry in the global financial markets. Investors who own these US Treasury bonds would become concerned about getting their money back, so they might start selling them quickly. This would cause the prices of these US Treasury bonds to drop, and US interest rates would go up. It would become more expensive for people and businesses in America to borrow money.
- Economic Slowdown: When borrowing becomes more expensive, it affects the economy. Businesses would likely find it harder to get loans to expand their operations, and individuals might have difficulty getting affordable loans for items like buying a car or a mortgage for buying a house. This could lead to a slowdown in economic growth and job creation, and it could cause widespread unemployment.
- Stock Market Decline: The stock markets, American and others, would also likely be affected. Investors would be worried about the overall health of the economy, so they might start selling their stocks to preserve their wealth. This most likely would cause share prices to drop. People who have invested in stocks and sold their shares in a panic could lose money. It could also make it more difficult for companies to raise money by selling shares, which might hinder their ability to grow and create new jobs.
- Global Impact: The US is a major player in the global economy (the largest economy in the world), so a default would have worldwide consequences. Many countries and organizations hold US Treasury bonds as part of their investments or reserves. If the US were to default, these entities would suffer financial losses, it could create instability in the global financial system, and severely damage America’s reputation as a trustworthy borrower. It might also weaken the US dollar, which is widely used in international trade and finance. Other nations would likely try to exploit the situation and spread global doubt about the value of the US dollar, American institutions, and US leadership.
- Social and Political Unrest: People might lose trust in the US government’s ability to manage its finances, leading to unrest and protests. It would probably cause a lot of anxiety and uncertainty for individuals and families as the American economy struggles and job opportunities become scarce.
To avoid these serious consequences, the American government usually takes steps to prevent a default. The usual course of action is for the US Congress to authorize more government borrowing so the US can keep paying its bills. This time the Republicans who control the House of Representatives are trying to use the looming deadline to their advantage. They are playing a risky game of brinkmanship with the White House.
Impact on Canada and Canadian Investors
It is important to remember these are potential impacts, and the exact consequences would depend on the specific circumstances surrounding a US default. Governments and central banks typically take measures to mitigate the effects of such events and stabilize their respective economies. I am sure the Bank of Canada (BoC) is aware of what is happening in the US and are planning accordingly. Nonetheless, a US default would undoubtedly present challenges for Canada due to the countries’ close economic relationship (Canada and the USA are each others largest trading partner). Here are some of the ways it could affect Canada in general:
- Economic Impact: As Canada’s largest trading partner, any disruption in the US economy would have a direct impact on Canada. A US default could trigger an economic slowdown or recession in the US, which would lead to reduced demand for Canadian exports. The decline in trade activity could also affect the demand for the Canadian dollar, putting downward pressure on the value of the Canadian dollar. Canadian businesses that rely heavily on exporting to the US would face challenges as their sales decrease. This could result in job losses, reduced investment, and a slowdown in the Canadian economy.
- Currency Exchange Rates: During times of uncertainty or market turmoil, investors often seek safe-haven currencies and assets. A US debt default could lead to global economic instability and a decrease in investor confidence in the US economy and the US dollar. As a result, investors may seek to sell off their US dollar holdings, causing its value to decline relative to other currencies, including the Canadian dollar. The Canadian dollar could benefit from its perceived stability and become a preferred safe-haven currency. This could potentially strengthen the Canadian dollar against the American dollar as investors move their funds into Canadian assets at the expense of the US dollar. For Canadian consumers, this would make buying products in the US less expensive. However, for businesses exporting to the US, their products would be more expensive which could lead to lower demand.
- Financial Market Volatility: If the US defaults, it would send shockwaves through the global financial markets, and Canadian stock markets would not be immune. Investor uncertainty and risk aversion could lead to increased volatility, likely resulting in declining stock prices. Canadian investors would feel the impact as stock markets plunge, and portfolios take a hit. The fear and uncertainty in the air would make investors anxious, and panic selling might take hold. On a positive note, it could also affect Canadian bond markets, as Canadian government bonds may be seen as a safer alternative during times of uncertainty and lead to increased demand. As a result, interest rates could fall, making borrowing costs more favorable for Canadian businesses and consumers.
- Trade and Investment Confidence: A US default could erode confidence in the global economy and financial system. This could impact investor sentiment and decision-making, leading to reduced investment in Canada. Uncertainty and market volatility may cause businesses to delay or scale back their investment plans, affecting economic growth and job creation in Canada.
- Commodity Prices: Canada is a major exporter of commodities such as oil, natural gas, and minerals. The Canadian energy sector in particular is closely tied to the American market. A US default could lead to a decrease in US economic activity and energy consumption, which would impact Canadian energy exports. Lower demand for Canadian oil and gas could result in reduced revenue for energy companies and have negative effects on employment in the sector. As well, the prices of other commodities, such as minerals and metals, are often influenced by global market conditions, including the strength of the US economy. If a US default led to an economic downturn, it could lower global demand for commodities, which may negatively affect Canadian commodity exports and, consequently, the Canadian dollar. It would also lead to lower tax revenues for the government which collects taxes on all exports.
If the US were to default on its debt, it would be a turbulent time for us investors. Canadian investors, like investors in America and throughout the world, would likely face losses on their investments. The value of stocks and other investments linked to the US market would likely plummet. That would be painful, to say the least. Keep in mind, any losses would only be on ‘paper.’ They do not become actual losses until you sell those shares. If time is on your side, you could hold onto to your shares and wait for the markets to rebound (this is my preferred course of action).
However, crises can also bring opportunities. While a US default would create challenges, sharp investors could find a few hidden gems in the chaos and seize the chance to buy undervalued stocks, betting on a market recovery.
I do not know what will happen in the North American stock markets if the US defaults, but in investing, flexibility and the ability to seize opportunities can make all the difference. If the US does default, keep your wits about you, and remember that even amidst the chaos, there will be opportunities to increase your wealth. 😊