It came to this.
Because of the debt ceiling crisis, one corner of financial markets sees the US government as a riskier borrower in the next month or so than Bulgaria, Croatia, Greece, Mexico, the Philippines and a host of other countries that were never remotely considered pivotal in the modern global financial system.
Don’t get me wrong. I hold Treasuries in my personal portfolio and, with one notable exception, so far there is no sign that investors around the world are turning away from Treasuries – or the US dollar or the US stock market, for that matter. The United States is the center of world finance and I hope it stays that way.
However, an important but often overlooked sector of financial markets – the $30 trillion market for credit default swaps – says that the debt ceiling impasse is serious indeed. Short-term costs of insuring against US debt defaults are rising now.
What’s more, there are indications that Washington’s periodic dalliances with debt defaults are already having subtle long-term negative effects on global markets.
Janet L. Yellen, the Treasury secretary, said that if a US debt default occurs, it will be an “economic and financial catastrophe of our own making.” All catastrophes have costs, and markets struggle to value them.
the impasse
President Biden began discussing the debt ceiling with House Speaker Kevin McCarthy and other congressional leaders, without making much headway. As things stand, the Treasury says it will exhaust its trove of “extraordinary measures” and hit the debt ceiling in June. If Congress doesn’t act by then, the United States could run out of money. It is conceivable that she would stop paying her bills, including millions of Social Security checks, and that she might default on her debts for the first time.
The stock market has been focused on other issues – persistent inflation, high interest rates, bank failures, the possibility of an imminent recession and the intentions of the Federal Reserve, which has been tightening financial conditions for over a year. But if there is no resolution of the debt ceiling dispute until the last minute, a sharp drop in the stock market would not be surprising. This has happened before, even without an actual pattern. Eventually, the stock market recovered.
Treasury bonds are typically seen as the safest investments. But now, one-month Treasuries due in June are being seen in markets as potential pain points. Their yields have skyrocketed in the last two weeks, pushing them above the two- and three-month bill yields. This is not typical.
In two or three months, the logic goes, the debt ceiling crisis will be behind us. Meanwhile, one-month bills carry unusual risks. But some investors, like William H. Gross, who was known as the “bond king” when he headed Pimco, say a default will be avoided and, at current prices, one-month Treasuries are bargains.
They very well might be, but that’s only because they’re considered risky. However, Treasury bills must be risk-free assets. Virtually every financial asset on the planet is priced relative to Treasuries, so you could argue that if the US Treasury defaulted, there would be no safe place to go. Under these circumstances, it is difficult to assess the safety of anything in the financial world.
Standard Insurance
Short-term Treasuries are not the only asset class directly affected by the US debt ceiling. Concerns also crystallized in the credit default swap market. This is an arena for deep-pocketed institutional investors – hedge funds, banks, pension funds and the like – and it’s not a place I tend to spend a lot of time thinking about. But credit default swaps provide insight into the gratuitous damage that political dysfunction in Washington is inflicting on US credit.
Consider that credit default swaps are essentially safe. For a defined period, investors can obtain protection against losses arising from the default of a company or government. The United States remains the world’s financial powerhouse. But until 2011, it was also in a select group of countries with the highest credit rating in the world. That year, however, Standard & Poor’s downgraded its credit rating by one notch because of the collapse of the debt ceiling.
Germany, on the other hand, still has an impeccable AAA credit rating. Although it lacks the influence of the United States, it is not surprising that Germany is considered a better credit risk. But the extent to which this is now true is surprising.
“Look at the credit default swap market and you get a sense of how much the United States is being hurt by these debt ceiling crises,” said Richard Bernstein, former chief investment strategist at former Merrill Lynch, who runs his own company, Richard Conselheiros Bernstein.
I looked. While the probability of actual debt default is still low, the cost of insuring US bonds over the next 12 months was about 50 times the price in Germany and about three to eight times that of countries such as Bulgaria, Croatia, Greece, Mexico and the Philippines. This agrees with the FactSet data. Over longer periods – three, five and 10 years – the cost of insuring against US defaults falls.
As you would expect, over longer periods the US is considered safer than countries with weaker credit ratings, but it is still about three times as expensive to insure US debt as it is for Germany. And yields on German sovereign bonds are generally lower than those on Treasuries, Bernstein noted. There are many reasons for this, but an important one is the security of the German debt. “Even when resolved, these debt crises put the United States at a long-term competitive disadvantage,” he said.
a longer view
In his last annual letter to Berkshire Hathaway shareholders, Warren Buffett wrote of his continued optimism about America’s financial future.
“Despite our citizens’ penchant – almost enthusiasm – for self-criticism and self-doubt, I have yet to see a time when it makes sense to place a long-term bet against America,” he said.
I share this optimism, but I confess that I am worried. The debt ceiling crisis is a symptom of political dysfunction. Strangely, the United States has the ability to pay its debts, but it may not do so due to its inability to reach political consensus.
So what is to be done?
As Mr. Buffett, I believe most people should invest for the long term, using low-cost index funds. But I am not entirely confident that the United States will act in its own best interests. So, unlike Mr. Buffett, I believe investors should own stocks and bonds from around the world, not just the United States. I’m hedging my bets, long term and short term.
In the coming months, I am building up my relatively safe cash stash in government money market funds and federally insured savings accounts. No option will be completely safe if the US defaults, but I don’t see any better alternatives.
This is weird. In a crisis, even caused by the United States, investors tend to seek refuge in Treasury bonds. This happened in 2011 and is likely to continue to happen unless and until America finally loses its luster.
For now, be careful with your own money – and expect your elected officials to uphold all of America’s faith and credit.
