We thankfully lack market experience in situations where the world's largest bond issuer, which also presides over the world's reserve currency and currency of choice for denomination of the majority of the globe's financial transactions, decides to willingly default. However, we believe it is safe to say that a U.S. sovereign default would be extremely negative for U.S. (and by contagion) global equity markets. The 13% decline in U.S. equities in the first week of August 2011, in the aftermath of the last near-default and subsequent ratings agency downgrade, provides some frame of reference. Credit markets would likely suffer materially, if not catastrophically, as well.
Perversely, the likely impact of a sovereign default on U.S. Treasuries to U.S. Treasuries, themselves, is more ambiguous. Certainly a default event would frighten, confuse and unnerve a large group of Treasury market investors — and at PIMCO we would re-evaluate our Treasury portfolio positioning. However, a default event is an extraordinarily damaging event to not just the Treasury, but all of “USA Inc.” And while many assets would certainly flee, some investors beholden to dollar-denominated assets may decide to move up in the capital structure of USA Inc. — shedding equities in favor of sovereign debt securities. Their line of thinking would be that default will lead to deeply negative growth, declining equity markets, and therefore ultimate realization from Congress that perhaps this was a mistake — and that Congress should, in fact, pay its obligations. This would mean Treasuries (particularly the front end of the yield curve) could expect to see new demand, much like they did in the aftermath of the August 2011 rating downgrade.
Josh Thimons is a managing director and portfolio manager in the Newport Beach, Calif., office, focusing on interest rate derivatives.
Libby Cantrill is an executive vice president in PIMCO's executive office, where she helps monitor, analyze and coordinate the firm's response to public policy issues, including regulatory and legislative issues.