As lawmakers continue to scramble to raise the debt ceiling before the Treasury runs out of money on “X-date,” some investors are considering the potential effects a U.S. debt default would have on the stock market.
It’s somewhat unclear exactly how the stock market will be affected, given that the U.S. has never defaulted. That is to say that the U.S. has never defaulted in any comparable way to what could happen as soon as June 1. But at the very least, it is safe to say that nothing good would come of it.
Indeed, the most immediate effect of the country defaulting would be sky-high lending rates. As credit raters downgrade the quality of U.S. credit, the benchmark rate will likely rapidly rise. Most economists agree this rise in rates would likely beget a notable increase in unemployment and spur an accompanying recession, the magnitude of which remains unknown.
The Stock Market and a Default
As such, the stock market, which largely relies on the perception of business conditions in the country, would probably fall, reflecting the pinched financial state of the country.
According to Brookings Institution analysts, a default would deteriorate financial systems in the country in substantial ways:
“Worsening expectations regarding a possible default would make significant disruptions in financial markets increasingly probable… such financial market disruptions would very likely be coupled with declines in the price of equities, a loss of consumer and business confidence, and a contraction in access to private credit markets.”
Treasury Secretary Jannet Yellen has laid out expectations that the Treasury will run out of its so-called “extraordinary measures” funding as early as June 1. As the clock winds down, it’s no surprise to see investors grow increasingly skittish over the potential of a default-fueled stock market crash.
While this isn’t exactly the first time the U.S. has been forced to sort out its debt cap this late in the game, the country faced a similar debt ceiling crisis even as recently as 2021. However, the polarized state of Congress has some nervous that a U.S. default may be inevitable.
Stock Market on Edge Ahead of Debt Ceiling Deadline
The U.S. has never defaulted before in its history. As such, speculations over a default’s impact are somewhat uninformed, although the nation’s top economists uniformly agree the event would be devastating, especially if the default isn’t quickly corrected.
“If Treasury securities are no longer perceived as risk-free by global investors, future generations of Americans would pay a steep economic price,” wrote Moody’s analysts.
According to the White House’s Council of Economic Advisors (CEA), simulated debt defaults have resulted in catastrophic effects on the U.S. stock market. The CEA said:
“In the third-quarter of 2023, the first full quarter of the simulated debt ceiling breach, the stock market plummets 45%, leading to a hit to retirement accounts; meanwhile, consumer and business confidence takes substantial hits, leading to a pullback in consumption and investment”
As the CEA estimates, a 45% drop in equity prices would rank as one of the worst stock market pullbacks in recorded history. The CEA also estimates a default would raise unemployment by as much as 5%.
“Without the ability to spend on counter-cyclical measures such as extended unemployment insurance, Federal and state governments would be hamstrung in responding to this turmoil and unable to buffer households from the impacts,” the CEA noted.
With just days until “X-date,” investors around the country are holding their breath. The latest news out of Capitol Hill shows that President Joe Biden and House Speaker Kevin McCarthy are quietly inching towards an agreement on the debt ceiling, currently about $70 billion apart on a multi-trillion-dollar deal.
“We worked well past midnight last night,” McCarthy told reporters on Thursday. “There’s still some outstanding issues and I’ve directed our teams to work 24/7 to try to solve this problem.”
On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.