What happens to markets if the US defaults?

Time is running out for Washington to raise the country's borrowing limit and avoid a default. Wall Street isn't panicking yet. But if the unthinkable happens, a default could strike financial markets like an earthquake.

Time is running out for Washington to raise the country's borrowing limit and avoid a default. Wall Street isn't panicking yet. But if the unthinkable happens, a default could strike financial markets like an earthquake.

"If we just get higher longer-term interest rates, we'd be lucky," said John Briggs, Treasury strategist at the Royal Bank of Scotland.

What might markets look like after a default?

The tremors from even a short-lived default could take unpredictable paths. Stocks, bonds and the dollar would likely plummet in the immediate aftermath.

There's wide agreement among economists that a default would drive up borrowing costs for everybody. U.S. Treasury yields act like a floor for other lending rates, so raising them makes it more expensive for Americans to take out mortgages, for corporations to finance new spending and for local governments to borrow.

But analysts say predicting exactly how a default would play out in stocks, bonds and currency in the hours and days following the Aug. 2. debt ceiling deadline is practically impossible.

"If I were to draw a flow chart, it becomes so complex it's impossible to analyze the impact of a default," said Guy LaBas, chief fixed income strategist at Janney Montgomery Scott.

When pressed, investors say the immediate aftermath could look like the financial crisis in September 2008. Stocks would lead the way down. In the month following Lehman Brothers' bankruptcy, for instance, the Standard & Poor's 500 index lost 28 percent.

Gold may offer some refuge. Fear has driven traders into precious metals in droves in recent years, but gold is at a record $1,594 an ounce, without taking inflation into account. But two places where traders usually hide -- the dollar and U.S. Treasurys -- are likely to sink as the world's investors flee the U.S. There would be few places to hide.

A deeper fear is that a default could freeze the short-term lending markets that keep money moving throughout the global financial system. Treasurys and other government-backed debt are widely as used collateral for loans in these markets.

A default and a downgrade of U.S. debt by rating agencies would shake the trust in that collateral, Briggs said. Lenders could respond by demanding borrowers to post more collateral, forcing them to sell other investments to meet those demands. A similar selling cycle spread turmoil across markets when Lehman Brothers collapsed in 2008.

But the fallout from a U.S. default could be much worse.

"I don't even want to think of the ripple effects," Briggs said.

Indeed, most analysts agree that if the world's largest economy reneges on its debts, the consequences would be catastrophic. That's why so far they've trusted Congressional Republicans and President Barack Obama to reach a deal.

Federal Reserve Chairman Ben Bernanke certainly drew a dire picture in testimony before the Senate Banking Committee on Thursday. He said a default would be a "calamitous outcome" and "create a severe financial shock." The global financial system relies on Treasurys, backed by the world's largest economy and long considered one of the world's safest bets.

"A default on those securities would throw the financial system potentially into chaos," Bernanke said.

The widespread selloff that might trigger could have one benefit, Briggs and others say. Panic-selling might force Washington to quickly agree to raise the debt limit. Think back to September 2008 for some historical perspective. After the House of Representatives voted down the bailout bill to create the Troubled Asset Relief Program on Sept. 29, the Dow Jones industrial average nosedived 777 points. Congress made an about face and four days later passed the TARP bill. President George W. Bush quickly signed it into law.

"We're setting up for a TARP-like moment," said Neil Dutta, U.S. economist at Bank of America-Merrill Lynch. "The politicians don't come to a resolution, but the market forces a resolution."

Traders are still banking on a deal to increase the borrowing limit before the Aug. 2 deadline. That's one reason stocks and bond yields have remained relatively stable thus far, even after Moody's and Standard & Poor's warned they may soon take away the country's top credit rating.

"What would shock is if Washington failed to beat the deadline," said Tony Crescenzi, market strategist at Pimco. Crescenzi and other investors believe the negotiations could drag on until the last minute.

Markets would likely greet a deal with a "relief rally," analysts say. The effect would be the reverse of a default: Stocks, corporate bonds and the dollar all jump.

"The market will react well to it," said David Kelly, chief market strategist at J.P. Morgan Funds. Kelly said a deal would lift the uncertainty hanging over investors, especially those too worried to buy stocks now. After President Bush signed the TARP into law in 2008, for instance, the Dow made large jumps, adding as many as 946 points in a week.

When Washington finally agrees to raise the debt ceiling, Treasurys could drop because investors would be more willing to take risks in other investments, Kelly said. That's how they normally trade: Good economic news pushes Treasury prices down and yields up.

The relief may not last long. If the agreement leads to deep spending cuts, Wall Street economists say it will likely drag down economic growth. Similarly, in late 2008, the wild gains evaporated as the financial crisis took hold. The S&P bottomed out in March 2009.

Federal spending makes up 8 percent of gross domestic product, a broad measure of the economy. Goldman Sachs economists estimate that a deal to cut $2 trillion in spending could take 0.8 percentage points off economic growth next year. The bank already predicts modest real GDP growth of 3.1 percent in 2012. Knock off a quarter of that and the economy won't look much better than it does now.

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