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The probability of a catastrophic US debt default has more than tripled since the start of the year, MSCI says

Matthew Fox 

Mar 2, 2023, 1:15 PM

Tom Brenner/Reuters

• Chances of a US debt default have more than tripled since the start of the year, according to MSCI.
• MSCI said trading activity in US government credit default swaps have surged as investors buy insurance on a potentially catastrophic event.
• A split Congress has just a few months to pass a spending bill to avoid the default. 

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The chances of a catastrophic US debt default have more than tripled since the start of the year, according to a recent note from MSCI. 

The US debt ceiling was hit in mid-January and since then the US Treasury has been taking extraordinary measures to avoid a default and keep the government funded until sometime in June.

Now the clock is ticking for a split Congress to come to an agreement and pass a spending bill to avoid a default on US debt, and some investors are getting uneasy based on the trading activity in credit default swaps on US government one-year debt.

Credit default swaps are a form of insurance against issuers not making their scheduled payments on their debt.

The trading instrument was successfully used by some investors who bet against the housing market in 2008, including Michael Burry of Scion Capital. Protection payouts on the CDS are triggered when a debt payment is missed. 

"Implied default probabilities have increased to levels not seen since the 2013 debt-ceiling debate," MSCI said, highlighting that probabilities of a debt default have soared from 3.3% at the start of January to 11.3% as of last week.

While the surge CDS spreads on US government bonds has been quick and massive, it's not unprecedented, as the CDS spreads are approaching similar levels seen during the 2011 and 2013 debt-ceiling showdowns. During those battles, Congress reached an agreement at the last minute to avoid a default. 

"In the absence of legislative agreement, CDS trading volume on the U.S. government may continue to strengthen as summer approaches, and the possibility of missing payments on U.S. Treasurys looms larger," MSCI said.

In the unprecedented event that the US does default on its debt, the consequences go way beyond treasury holders not receiving their payments.

Such a default could grind the economy to a halt and spark extreme volatility in interest rates, as much of the world's interest rate levels are in part influenced by the "risk-free" nature of US government debt. Additionally, millions of seniors would be at risk of losing their social security benefits. 

"Major market dislocation and a sharp slowdown in economic activity could both be realistic possibilities" in the event of a US debt default, MSCI said.