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    Debt Ceiling Standoff Raises Risks for ‘Risk-Free’ US Bonds

    EbrahimBy EbrahimJanuary 31, 2024No Comments7 Mins Read

    We have come to this.

    Because of debt ceiling crisis, a corner of the financial markets sees the American government as a riskier borrower over the next month than Bulgaria, Croatia, Greece, Mexico, the Philippines and a host of other countries that have never been considered pillars of the modern global financial system.

    Do not mistake yourself. I hold Treasuries in my personal portfolio and, with one notable exception, there is no indication so far that investors around the world are abandoning Treasuries – or the US dollar or the US stock market, for that matter. elsewhere. The United States is at the heart of global finance, and I hope it remains so.

    Yet an important but often overlooked area of ​​financial markets – the 30 trillion dollars credit default swap market — says the debt ceiling issue is really serious. The short-term costs of insuring against a U.S. debt default are skyrocketing today.

    Moreover, there is some evidence that the Washington periodical flirtations with non-payment are already having subtle long-term negative effects on global markets.

    Janet L. Yellen, Secretary of the Treasury, said that if a U.S. default occurs, it will be “an economic and financial catastrophe of our own making.” All disasters have a cost and markets find it difficult to value them.

    The impasse

    President Biden began discuss the debt ceiling with President Kevin McCarthy and other congressional leaders without making much progress. As things stand, the Treasury says it will exhaust its trove of “extraordinary measures” and reach the debt ceiling sometime in June. If Congress does not act by then, the United States could run out of money. It is conceivable that she will stop paying her bills, including millions in Social Security checks, and default on her debt for the first time.

    The stock market has focused on other topics – persistent inflationhigh interest rate, bank failuresthe possibility of an imminent event recession and the intentions of Federal Reserve, which has been tightening financial conditions for more than a year. But if the debt ceiling dispute is not resolved until the last minute, a sharp decline in the stock market would not be surprising. This has happened before, even without a real defect. Eventually, the stock market recovered.

    Treasury bonds are normally considered the safest investments. But now one-month Treasuries maturing in June are seen in markets as potential hot spots. Their yields have soared over the past two weeks, putting them above yields on two- and three-month bills. This is not typical.

    Logically, in two or three months, the debt ceiling crisis will be behind us. Meanwhile, one-month bills carry unusual risks. But some investors, like William H. Grosswho was known as the “bond king” when he ran Pimco, says a default will be avoided and that at current prices, one-month Treasuries are a bargain.

    That may be the case, but that’s only because they’re deemed risky. Yet Treasuries are supposed to be risk-free assets. Virtually every financial asset on the planet is valued against Treasury bonds, so one could argue that if the U.S. Treasury defaulted, there would be nowhere safe to go. Under these circumstances, it is difficult to assess the security of anything in the financial world.

    Insurance by default

    Short-term Treasuries aren’t the only asset class directly affected by the U.S. debt ceiling. Concerns have also crystallized in the credit default swaps market. This is an area reserved for deep-pocketed institutional investors – hedge funds, banks, pension funds, etc. – and it’s not a place I usually spend a lot of time thinking about. But credit default swaps provide insight into the gratuitous damage that political dysfunction in Washington damages the credit of the United States.

    Consider that credit default swaps are essentially insurance. For a defined period, investors can obtain protection against losses resulting from a company or government default. The United States remains the world’s financial power. But until 2011, it was also part of a select group of countries with the highest credit rating in the world. But that year, Standard & Poor’s lowered his credit rating went up a notch due to the debt ceiling debacle.

    Germany, on the other hand, still enjoys an excellent triple-A credit rating. Although it doesn’t have the clout of the United States, it’s not surprising that Germany is considered a better risk credit. But it is astonishing how true this is today.

    “Look at the credit default swap market and you will get an idea of ​​the extent to which the United States is affected by these debt ceiling crises. » said Richard Bernstein, a former chief investment strategist at the former Merrill Lynch who runs his own firm, Richard Bernstein Advisors.

    I watched. Although the likelihood of an actual default is still low, the cost of insuring U.S. bonds over the next 12 months was about 50 times that of Germany and about three to eight times that of Germany. from countries like Bulgaria, Croatia, Greece, Mexico and Mexico. The Philippines. That’s according to FactSet data. Over longer periods – three, five and ten years – the cost of insuring against a US default decreases.

    As might be expected, over longer periods of time, the United States is considered safer than countries with lower credit ratings, but it remains about three times more expensive to insure U.S. debt than that of of Germany. And yields on German sovereign bonds are generally lower than those on Treasuries, Mr. Bernstein pointed out. There are many reasons for this, but one of them is the security of German debt. “Even when resolved, these debt crises place the United States at a long-term competitive disadvantage,” he said.

    A longer term vision

    In his last annual letter To Berkshire Hathaway shareholders, Warren Buffett expressed his continued optimism about the financial future of the United States.

    “Despite our citizens’ penchant – almost enthusiasm – for self-criticism and self-doubt, I have yet to see a time when it would have made sense to bet against America in the long term,” he said. he declared.

    I share this optimism, but I admit that I am worried. The debt ceiling crisis is a symptom of political dysfunction. Oddly, the United States has the capacity to pay its debts, but cannot do so due to its inability to reach political consensus.

    So what to do?

    Like Mr. Buffett, I think most people should invest for the long term, using low-cost index funds. But I am 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 all over the world, not just the United States. I hedge my bets, long term and short term.

    Over the next couple of months, I’m building up my relatively safe cash stash in government money market funds and federally insured savings accounts. No option will be completely safe in the event of US default, but I don’t see a better alternative.

    It’s strange. In the event of a crisis, even one caused by the United States, investors tend to seek refuge in Treasury bonds. This happened in 2011, and it will likely continue to happen unless the United States finally loses its shine.

    For now, be careful with your own money – and hope that your elected officials will preserve the full faith and credit of the United States.

    Ebrahim
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