If the U.S. defaults on its debt, here’s how it will impact your savings, cash investments — and 401(k)

President Joe Biden and House Speaker Kevin McCarthy met Tuesday to negotiate a deal that raises the $31.3 trillion borrowing limit and preserves the country’s full faith and credit. Afterwards, McCarthy told reporters he “didn’t see any new movement.” Another meeting is scheduled for next week after a Friday meeting was postponed.

Observers weren’t expecting an agreement Tuesday. But they do expect a deal to avoid a U.S. default.

Even a distant chance of a default is worrying. After the “X-date” when the government exhausts its capacity to pay all its bills, cash-management problems could ripple far beyond the federal government and capsize economies, investors and households, experts say.

Bank deposits would still have their coverage up to $250,000 due to Federal Deposit Insurance Corporation protections. Yet lending rates could soar higher, they note.

Even without the debt ceiling drama, interest rates have already been climbing and banks have already been tightening credit standards.

Meanwhile, money-market mutual funds with exposure to Treasury debt could have many institutional and retail investors asking for their money back, experts said.

Rising interest rates and bank sector wobbles have pulled more money into the conservative, highly liquid mutual funds that currently have more than $5.7 trillion in cash.

“This is the worst possible time to be having a stalemate,” said Urooj Khan, a professor at the University of Texas’ McCombs School of Business, where he studies financial crises.

Of course, there’s never a good time for the federal government to default. “It’s widely agreed that financial and economic chaos would ensue,” Treasury Secretary Janet Yellen said in an ABC interview Sunday. The “X-date” could arrive as early as June 1, Yellen has said.

Of course, cash is just one part of a portfolio to build and preserve wealth. At the Bipartisan Policy Center, the potential for a stock market sell-off that would gut retirement accounts worries some observers more than the implications of a potential default for cash investments.

A protracted default would slice 45% of value from the stock market, according to the White House’s Council of Economic Advisors.

And if that happened? “Your 401(K) is now a 201(K),” said Jason Fichtner, vice president and chief economist at the Bipartisan Policy Center, a Washington, D.C.–based think tank that promotes bipartisanship.

At a time when people have been extra vigilant about returns from savings — and the safety of their deposits — here’s a look at the implications of a default:

Bank deposits

Any default still doesn’t change the fact that the Federal Deposit Insurance Corporation ensures deposits up to $250,000 per depositor, per account, Khan noted.

Indeed, an FDIC spokesperson said, “people’s money in deposit accounts are still available to them on demand” and certificates of deposit “still accrue interest. Deposit insurance coverage remains the same.”

As the Federal Reserve increased the benchmark interest rate to address inflation, bank-account interest rates climbed with them. It might even be the peak moment to capitalize on yields from savings accounts and CDs, experts said.

However, immediately after any default, banks could come under pressure and need deposits to maintain liquidity, Fichtner said.

Banks would have “every incentive” to hold onto deposit accounts, so in the immediate aftermath they would likely keep their deposit rates competitive, he said. “We have never done this before. I hope we don’t find out,” Fichtner added.

However, if banks were under pressure to keep deposit rates competitively priced, Fichtner and Khan said lending rates for all sorts of credit to households and businesses would soar.

Consumer-facing credit, like mortgages and car loans, tend to follow yields on Treasury debt. Price and yield move in opposite directions. So if the market price on Treasury debt declines because it’s no longer viewed as an investor safe haven, that yield jump would have major consequences.

“Everything gets benchmarked on them,” Khan said of Treasury debt. So if Treasury yields rise because of the heightened risk, credit for “all other assets will reflect that risk as well.”

The White House agrees in this recent blog: “The ability of households and businesses, especially small businesses, to borrow through the private sector to offset this economic pain would also be compromised. The risks engendered by the default would cause interest rates to skyrocket, including those on the financial instruments that households and businesses use — Treasury bonds, mortgages, and credit card interest rates.”

Mortgage rates that are now over 6% could jump to 8.4% in the event of a default, according to Thursday projections from Zillow
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Increased rates from a default would make a monthly mortgage payment 22% more costly by September, the real estate company said.

Read: Here’s where investors may turn to ‘hide’ as U.S. debt-ceiling deadline looms based on 2011 market reaction

Even negotiations can drive up rates. Mortgage rates increased by around 0.7 to 0.8 of a percentage point for two months during 2011 debt-ceiling negotiations and slowly eased after the deal, according to the White House’s Council of Economic Advisors for the Biden administration.

Now, short-term Treasury yields already show fraying nerves as spooked investors eye debt that would come due right around the X-date.

The yield on a three-month Treasury bill
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5.188%
recently increased to a level not seen since January 2001. Yields for a one-month Treasury bill
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5.501%
hover at levels that stretch back to 2008.

The short-term yield increase could be an opportunity at a time when T-bills were already an alluring place for cash, according to Bill Gross, the former co-founder of Pimco, an investment management firm that focuses on active fixed-income management.

Money-market funds

Money-market mutual funds consist of holdings like high-quality, fast-maturing government debt. While considered extremely low risk, the deposits in these mutual funds are not subject to FDIC coverage.

Ten straight Federal Reserve interest-rate hikes have turned money-market funds into a more enticing destination for yields. Bank system worries pushed even more money to the funds from bank system deposits.

Money-market funds held a record-breaking $5.73 trillion as of this week, according to Peter Crane, president of Crane Data, which tracks the money market industry. The fund amounts have been setting and resetting records on size for two months, he said. Investors poured $300 billion into them in the three weeks prior to March 29.

Of the $5.7 trillion, more than $3.75 trillion is institutional investor money and another $1.86 trillion comes from retail investors, according to Crane Data.

Different sorts of money-market funds have different degrees of exposure to a default crisis, Crane and others explained. There are government money-market funds, a portion of which are Treasury money-market funds. “Prime” money-market funds can invest in government debt and securities, but also low-risk commercial holdings. Municipal money-market funds — debt securities issued by local or state governments — are yet another option.

As interest rates keep rising, Crane said the chief investment for the funds are repurchase agreements. These agreements, super short-term loans backed by collateral like Treasurys, constitute over $3 trillion, more than 57%, of the funds’ holdings, according to Crane.

Treasury debt is a distant second, constituting $1 trillion, or 18%, of the funds, Crane said.

So what happens to holdings in a money-market fund in the remote chance of a default?

One threat would be “breaking the buck,” said Khan, at University of Texas.

Money market funds seek to keep their net asset value at a stable $1 per share and breaking the buck occurs when the share price edges lower than $1.

The implication of breaking the buck is that you invested $100 bucks and now you’re going to get $98 dollars,” Khan said. “Breaking the buck essentially means that the investor does not get 100% back on their investment at that point in time.”

That occurred on September 16, 2008, one day after Lehman Brothers filed for bankruptcy when investors rushed to money-market funds to get their money back. The Federal Reserve and Treasury Department quickly had to support money-market funds in the wake of the Lehman collapse.

What if investors pulled out a huge amount of money en masse? Crane said much of that would likely surpass the FDIC’s deposit guarantee. “There’s nowhere to run,” he said. “It’s all big money. It’s all uninsured deposits.”

Still, the chance of breaking the buck in a heavy stream of redemption requests would be “far fetched,” according to Crane. For one thing, there have been reforms on the rules for such redemptions, he noted.

It’s possible the funds are changing up their Treasury debt holdings to minimize maturities around the X-date, Crane, Khan and others noted.

Major money-market fund managers, such as JPMorgan Chase & Co. JPM and Vanguard, did not respond to a request for comment.

“Safety and liquidity have always been, and will continue to be, our top priority objectives in managing money-market funds for our customers no matter the market conditions,” according to a spokesperson for Fidelity, another major money-market fund manager.

“Our money-market funds are positioned conservatively in light of debt-ceiling risks, and our funds invest in money-market securities of high quality and maintain high levels of liquidity,” the spokesperson told MarketWatch.

Read more:

Think 6% mortgage rates are too high? Here’s how bad it could get if the U.S. defaults on its debt.