How Wall Street is Preparing for a Debt Ceiling Showdown

If the federal government defaults on its debt, the effects could be disastrous, threatening to undermine the role of the United States at the heart of global finance and tip its economy into recession. But after the government hit its debt limit and approaches the day when it runs out of cash to pay its bills, the stock market is showing no signs of panic. The S&P 500 is up more than 7 percent for the year.

That’s because in simple terms stock investors face a binary choice: Either lawmakers make a last-minute deal to raise the country’s borrowing limit, as in the past, or the nation reneges on its obligations, with potentially catastrophic consequences that are difficult for investors to comprehend, much less reflect in stock prices.

The precise day when the government would run out of cash, known as the X-date, is unknown, which also complicates trading decisions for investors. It could come as soon as June 1, according to recent comments from Treasury Secretary Janet L. Yellen.

“What you are seeing is a consensus view that we will not cross through the X-date,” said Ralph Axel, an interest rate strategist at Bank of America. “At the moment that remains a low probability event that is hard to price.”

“It is really incumbent on Congress and the administration to deal with the debt ceiling, or increase the debt ceiling,” said John C. Williams, the president of the Federal Reserve Bank of New York, during a meeting with reporters in New York on Tuesday. “There are a million different ways that a default like that would affect the financial system and the economy in a negative way that are deeply profound and very hard to predict — therefore, it is absolutely essential that they deal with this promptly.”

The closest parallel to the current standoff is the brinkmanship over the debt ceiling in August 2011. In July, the S&P 500 traded near its high for that year. But by Friday, Aug. 5, when S&P downgraded the country’s credit rating, the index had dropped by over 10 percent. By the following Monday, the index had fallen more than 16 percent from its July peak.

Investors are aware of the risks of a repeat and, outside of the stock market, there are signs of caution creeping in. Already, investors have backed away from owning government debt that expires around the time the government is expected to run out of money.

Last week, the Treasury Department borrowed money for four weeks at an interest rate of almost 6 percent, well above what it has recently paid to borrow for much longer periods, reflecting investors’ unease over what might happen around the X-date.

The cost to protect against the government not paying its debts, using derivatives contracts called credit default swaps, has also shot higher, suggesting a rising probability of default.

Gold prices have risen more than 10 percent over the past two months, attributed in part to investors seeking out the safety of the precious metal, which is expected to retain its value through bouts of market turmoil. It’s hard to untangle some of this trading activity from broader worries about the economy, especially after the recent series of banking troubles, as many investors have already positioned their portfolios defensively.

Still, even stock investors have begun to hedge their bets, buying derivatives that pay out if there were a sudden fall in the stock market in the coming months.

Stuart Kaiser, an equity analyst at Citigroup, said that he has also fielded questions from investors about which parts of the stock market are most dependent on government funding, such as health care and defense stocks. Those companies could be left with unpaid invoices in the case of a default or face cuts to future funding as part of a negotiated deal in Washington.

“People are dusting off their 2011 playbook and sharpening their 2023 pencils,” he said.

Jeanna Smialek contributed reporting.

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