The U.S. seemed to take a few steps back from the brink of debt default Friday, but the edge stills seems dangerously close. House Republicans have a proposal that would lift the statutory debt limit, but only until Nov. 22. Five weeks from now, in other words, we could be exactly where we are currently. It still makes sense, then, to ask: How would a debt-ceiling breach play out in Canada?
To answer that question is to enter the realm of guesswork rather than forecasting, since there is no historical precedent to turn to. But the guesses all seem to start from the assumption that there are essentially two types of U.S. default scenarios: One in which investors more or less keep their cool, and one in which they don’t. It’s hard to know, though, exactly what the turning point could be. Still, here’s how economists described the two scenarios to Canadian Business:
The “meh” default
Markets have been relatively calm so far, and they might stay that way even if Uncle Sam stumbles over the debt ceiling. That’s because a U.S. default would be no regular default: It’s not that Washington doesn’t have the means to pay its creditors, it’s that political impasse won’t let it, said Derek Burleton, vice president and deputy chief Economist at TD Bank Financial Group. Even if the U.S. Treasury does not prioritize debt owed to bondholders over its other obligations, markets might view those missed payments as merely “delayed” and not foregone, said Douglas Porter, chief economist at BMO Capital Markets.
Some investors might react by moving capital from the U.S. to safe, stable Canada, putting some downward pressure on Canadian bond yields and pushing up the loonie, said Burleton. A high Canadian dollar would hurt exporters, noted Avery Shenfeld, chief economist at CIBC World Markets, but lower long-term rates would provide “a bit of cushion” by keeping borrowing costs down. Of course, rock-bottom rates and a strong Canadian dollar, he added, are the opposite of what the Canadian economy needs right now in order to kick its current addiction to household debt and condos and switch to a more sustainable growth model fuelled by exports and business investment.
Even if catastrophe is averted, the U.S. might still pay a price for messing with bondholders, though. “The bigger issue is the permanent danger to how the world would view the U.S. credit worthiness,” says Porter. A debt-ceiling breach and, worse, a missed debt payment would “set a historical precedent,” concurred Burleton. While investors might keep a poker face through the crisis, they might punish the U.S. later on, gradually driving up Treasury yields and making it forever more expensive for Washington to borrow.
At the end of the day, though, the biggest threat to Canada might likely come not from financial markets, but from what a debt ceiling breach would do to U.S. consumer and business confidence and thus the pace of growth south of the border.
The Armageddon default
This is a very far-fetched scenario. Getting economists to describe it is a bit like asking an astrophysicist to give you a detailed picture of what would happen if a giant asteroid hit the earth—no one really knows because, thank goodness, it has never happened before. Still, I asked.
If investors started panicking over a U.S. default, they would flee to where they normally seek refuge when doomsday nears: The Yen, the Swiss Franc, the Euro—and yes, even the very U.S. dollar, paradoxically. Not the loonie, though, which would probably take a hit, according to Burleton. “Canada is a good place to invest,” he says, “but it isn’t a proper safe-haven.” After all, he quips, we are and remain a small open economy, hardly a harbour from an end-of-the-world type financial event. Also, commodity prices would probably plummet, hardly a selling point for the loonie, noted Porter.
The Armageddon default would also likely temporarily decouple trends in U.S. and Canadian bond yields, which historically tend to move closely. U.S. long-term rates would spike, while investors in Canada would rush to the domestic fixed-income market, setting off a bond rally that would push Canadian yields down “substantially,” said Burleton. Needless to say, he added, the TSX would also sink.
The second scenario is no doubt terrifying, but don’t waste your Thanksgiving weekend fretting about it. The takeaway here seems to be that, as Burleton put it, “a debt ceiling breach isn’t necessarily a black swan event.” We might make it through relatively unscathed.
A more pressing concern, noted Shenfeld, is that protracted brinkmanship over the federal budget could subject the U.S. economy to a series of spending shocks—with the flow of federal funds being repeatedly cut off abruptly via either the shutdown or the debt ceiling—which could take a toll on the U.S. recovery and Canada’s GDP growth too.