By Steven C. Johnson
NEW YORK (Reuters) - As the standoff over raising the government's borrowing limit enters its final month, it's becoming harder for investors to avoid thinking the unthinkable: the world's most trusted borrower could soon renege on its debt.
The Treasury says it will be forced to default on its obligations if Congress does not raise the $14.3 trillion debt ceiling, which caps how much it can borrow, by August 2.
The Treasury has not specified which bills it wouldn't pay, but the prospect of its missing interest or principal payments on any outstanding debt is a terrifying one for Wall Street.
Even a temporary default would erode the United States' status as the world's most powerful economy and the dollar's role as the dominant global currency.
"It would be catastrophically bad to tell the world that the United States is willing to default on its obligations," said Gregory Whiteley, who helps manage $12 billion in assets at DoubleLine Capital in Los Angeles. "Even if the default only lasted a few days, the precedent would be set."
A default would undermine confidence in Treasuries, the world's safest asset and the benchmark for the global bond market, particularly if ratings agencies were to cut the United States' prized AAA credit rating.
If investors start demanding higher returns for holding riskier U.S. debt, the rise in bond yields would crank up borrowing costs for consumers and businesses. This in turn could tip a still fragile economy back into recession.
QUANTIFYING THE UNTHINKABLE
Republicans in Congress want the White House to commit to deep spending cuts before lifting the ceiling while Democrats favor adding tax increases on the wealthy. Talks collapsed two weeks ago, and compromise seems far off.
Even so, investors are not panicking. The benchmark 10-year Treasury yielded 3.09 percent on Wednesday. While above its 2011 low of 2.84 percent hit last week, that was still far below where it would be if markets felt default was imminent.
"I don't think the majority of Congress is so stupid as to visit an actual default on the United States," said David Kelly, chief market strategist at JPMorgan Asset Management. "Their constituents would never forgive them for playing fast and loose with the credit-worthiness that it took 230 years to build up."
But as the deadline nears, markets may grow more restive.
Standard and Poor's told Reuters last week it would waste no time cutting the top-notch U.S. credit rating if Treasury missed a $30 billion debt payment on August 4.
Robert Tipp, chief investment strategist at Prudential Fixed Income, with $240 billion in assets, said long-term interest rates could swiftly rise by up to 50 basis points.
Based on the projected budget deficit, that amounts to an extra $70 billion in interest costs -- a fairly hefty price to pay for a country already facing a large debt burden.
Robert Brusca, chief economist at Fact and Opinion Economics, reckons a default could be a lot more costly, knocking Treasury prices down 5 to 10 points in a day -- a violent and unusual move. "This could be a horror show."
DOLLAR AT RISK?
The turmoil would likely spread far beyond the bond market as Treasuries are the one asset invariably accepted worldwide as collateral. A downgrade could result in margin calls, unleashing a wave of selling in stock and other markets.
In a note to clients this week, Priya Misra, head of U.S. rates research at BofA-Merrill Lynch, suggested owning some S&P 500 "puts" in case the debt ceiling is not raised by August 2.
The dollar would be vulnerable, too. As the global reserve currency, it dominates world trade and is the one in which central banks store most of their savings.
But if the "full faith and credit" of the U.S. government comes under question, that would plant "a seed of doubt" for global investors, said Barclays chief currency strategist Jeffrey Young, and could erode the dollar's unique status.
Foreigners hold more than half of outstanding dollar-denominated U.S. government debt. China alone holds more than $1 trillion, according to Treasury data.
Even if Treasury were to make good eventually on missed payments, "there's no way to guarantee to foreign investors that the dollar, having sold off on a debt ceiling breach, will go back to where it was once things are resolved," said Steven Englander, who heads G10 FX strategy at Citigroup.
The short-term impact would likely boost the yen and Swiss franc, already up 10 percent against the dollar this year, short-circuiting a typical safe-haven bid for the greenback.
In the longer run, it could boost the euro.
"There have been plenty of warnings from around the world, notably China, that the United States is playing with fire," said Douglas Borthwick, managing director of Faros Trading.
"They wouldn't be able to dump $1 trillion in Treasuries overnight, but over time, they will probably prefer to hold European debt, given the Europeans look like they're willing to deal with deficit issues, while the United States does not."
PAINFUL BUT NOT A CATASTROPHE
Some contend failure to lift the debt ceiling need not end in catastrophe. Whiteley said Treasury tax revenues are sufficient to cover immediate interest and principal payments.
"But if you tell retirees we're not sending social security checks this month but we will be paying our Chinese debt holders, that makes for an uncomfortable situation," he said.
A few Republicans have even said a "technical" default that involves missing a few payments is manageable.
There's room for debate there. In 1979, Treasury was late in redeeming more than $100 billion of Treasury bills but that episode did not have a lasting effect on U.S. credibility.
However, that incident was the result of a freak printing problem, according to Richard Marcus, a finance professor at the University of Wisconsin-Milwaukee who later co-wrote a paper on the episode. Marcus' research did find it resulted in a 60-basis point interest rate premium on T-bills.
"People knew it was temporary, and I think that does make a difference," he said. "So it depends on how protracted it is. But I think it is a bad idea to miss payments, whether you are a homeowner, a company or a government."
(Additional reporting by Richard Leong in New York and Tim Reid in Washington; Editing by Chizu Nomiyama)