It has come to this.
Due to the debt ceiling crisis, part of the financial markets sees the US government as a riskier borrower than Bulgaria, Croatia, Greece, Mexico, the Philippines and a number of other countries that were never even remotely considered turning and The linchpin of the modern global financial system.
Do not get me wrong. I hold government bonds in my personal portfolio and, with one notable exception, there has been no sign of investors anywhere in the world abandoning government bonds – or the US dollar or the US stock market. The United States is at the heart of world finance, and I expect it will remain so.
But one important but often overlooked sector of financial markets — the $30 trillion credit default swap market — says the debt ceiling standoff is genuinely serious. The short-term cost of hedging against a US debt default is skyrocketing.
In addition, there are signs that Washington’s periodic flirting with a default on debt is already having subtle negative long-term implications for global markets.
Janet L. Yellen, the Secretary of the Treasury, said that if there were a US debt default, it would be “an economic and financial disaster of our own making.” All disasters have costs, and markets have difficulty valuing them.
The dead end
President Biden has begun discussing the debt ceiling with Speaker Kevin McCarthy and other leaders in Congress, without making much progress. As things stand, the Treasury says it will exhaust its fund of “extraordinary measures” and hit the debt ceiling sometime in June. If Congress doesn’t act by then, the United States could run out of money. It’s possible that the country will default on its bills, including millions in Social Security checks, and default on its debt for the first time.
The stock market has focused on other themes – persistent inflation, high interest rates, bank failures, the possibility of an impending recession and the intentions of the Federal Reserve, which has been tightening financial conditions for more than a year. However, if the dispute over the debt ceiling is not settled by the last minute, a sharp slump in the stock market would not come as a surprise. This has happened before, even without actual insolvency. Eventually the stock market recovered.
Government bonds are typically considered the safest investments. But now the one-month Treasury bills due in June are seen as potential trouble spots in the markets. Their yields have skyrocketed in the last week or two and are now above the yields on two- and three-month notes. That’s not typical.
Logically, in two or three months, the debt ceiling crisis will be behind us. One-month bills now harbor unusual risks. But some investors, like William H. Gross, who was known as the “king of bonds” when he ran Pimco, say a default can be averted and that month-long Treasury bills are a steal at current prices.
That may well be the case, but that’s only because they’re considered risky. Nevertheless, government bonds are supposed to be risk-free assets. Virtually every financial asset on the planet is priced relative to government bonds, so it could be argued that should the US Treasury default, there would be no safe place to turn. Under these circumstances, it is difficult to assess the safety of anything in the financial world.
failure insurance
Short-dated government bonds are not the only asset class directly affected by the US debt ceiling. Concerns also emerged in the credit default swap market. This is an arena for high-net-worth institutional investors — hedge funds, banks, pension funds, and the like — and not a place I typically spend a lot of time contemplating. But credit default swaps shed light on the needless damage that political dysfunction in Washington is doing to US creditworthiness.
Remember that credit default swaps are essentially insurance. Investors can protect themselves against losses from a corporate or government debt default for a defined period of time. The United States remains the financial power of the world. But until 2011 it was also among a select group of countries with the world’s highest credit rating. However, Standard & Poor’s downgraded its credit rating by one notch this year due to the debt ceiling debacle.
Germany, on the other hand, still has a top-tier credit rating of triple A. While it doesn’t have the clout of the United States, it’s not surprising that Germany is considered a better credit risk. But the extent to which that is now true is astounding.
“Look at the credit default swap market and you get a sense of how badly the United States has been affected by these debt crises,” said Richard Bernstein, a former chief investment strategist at old Merrill Lynch, who runs his own firm, Richard Bernstein Advisor.
I looked. While the probability of an actual debt default is still slim, the cost of insurance for US bonds over the next 12 months was about 50 times the price for Germany and about three to eight times the price for countries like Bulgaria, Croatia, Greece, Mexico etc the Phillipines. That’s according to FactSet data. Over longer time horizons—three, five, and 10 years—the cost of hedging against a US default falls.
As expected, the US is considered safer than countries with weaker credit ratings for longer periods of time, but hedging US debt is about three times as expensive as for Germany. And German government bond yields are generally lower than government bonds, Bernstein stressed. There are many reasons for this, but an important one is the safety of Germany’s debt. “Even if resolved, these debt crises put the United States at a long-term competitive disadvantage,” he said.
A longer view
In his most recent annual letter to Berkshire Hathaway shareholders, Warren Buffett wrote about his continued optimism about America’s financial future.
“Despite our citizens’ fondness — almost enthusiasm — for self-criticism and self-doubt, I have yet to see a time when it made sense to make a long-term bet against America,” he said.
I share that optimism, but I admit I’m worried. The debt crisis is a symptom of political dysfunction. Curiously, the United States is able to service its debt but may not because it cannot reach a political consensus.
So what to do?
Like Mr. Buffett, I believe most people should invest for the long term and use low-cost index funds. But I’m not entirely convinced that the United States will act in its own interest. So, unlike Mr. Buffett, I believe investors should own stocks and bonds from around the world, not just the United States. I hedge my bets long-term and short-term.
Over the next month or two, I’ll stock up on relatively safe cash holdings in government money market funds and government-insured savings accounts. No option will be completely safe if the United States defaults, but I don’t see any better alternatives.
That’s the weird thing. In a crisis, even one caused by the United States, investors tend to seek refuge in government bonds. That happened in 2011, and it likely will continue to do so, unless and until the United States finally loses its luster.
For now, be careful with your own money — and hope your elected officials maintain the full confidence and credit of the United States.