Debt ceiling disaster least likely of Deutsche’s three scenarios for US stand-off

8th October 2013

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Deutsche Asset & Wealth Management (DeAWM) has prepared three scenarios outlining the risks surrounding the US debt ceiling crisis with the country due to hit the $16.7trillion ceiling on 17th October.

It considers a quick solution, a drawn-out compromise in which the United States avoids default, and the worst-case scenario of default should the parties not reach an agreement.

Asoka Wöhrmann, Co-Chief Investment Office at DeAWM, summarises these three scenarios below with the  baseline scenario the most likely.

Baseline scenario
We are confident the opposing parties in the United States will reach an agreement. In our baseline scenario, we believe the shutdown will end soon and the debt ceiling will be raised in order to avoid technical default. In general, the impact on financial markets and the U.S. economy will be limited. The Fed could begin winding back quantitative easing, i.e., tapering its bond purchases, in December.

Risk scenario No. 1
If the shutdown does not end in time for the debt ceiling to be raised, technical default could still be avoided – for instance, if the U.S. Treasury were to prioritise payments of its obligations or take similar steps. In this scenario, we see political haggling continuing into November – at which time a solution would be found. The shutdown would have a significant negative impact on the economy during the fourth quarter, to the tune of around 1 percent of GDP for the entire year. The Fed would then begin winding back quantitative easing, i.e., tapering its bond purchases, during the first quarter of 2014 at the earliest.

Risk scenario No. 2
In the worst-case scenario, the United States would default on its debt in November, unleashing a disastrous effect on the economy. This scenario is the least likely to become reality. Technical default would prompt extreme market volatility, with strong turbulence occurring primarily in the U.S. bond and repo markets. U.S. bonds would rally until default occurred, followed by a sell-off as foreign central banks shed their Treasury bonds. Risk aversion would rise worldwide, and a global sell-off of risk-graded asset classes, such as stocks, would ensue. The economic damage would be significant and act as a drag on growth for some time. The resulting weakened confidence would create problems for all asset classes with higher risk levels. The economy would experience sluggish growth for some time. As a result, the likelihood of the Fed winding back quantitative easing, i.e., tapering its bond purchases, in the foreseeable future is negligible.

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