These days, clients frequently ask us whether the US government will default and what such an event would mean for investment strategy. This question clearly merits an accompanying warning that forecasting is difficult and the future is uncertain. To this I would add that, in reading this, you are about to get some free advice – worth every penny you paid for it. And now I will proceed.
Start with the event of default; that is, failing to make timely payment of interest and principal on government obligations. The current political battle is not about default in this sense; it is about raising the debt ceiling.
If the debt ceiling is not raised – and that still is a big if –- then someone won’t get paid because federal expenditures, week in and week out, will exceed federal revenues by a large amount. Who would that someone be and how long might this go on?
California, Here We Come
Fortunately, we have a role model for this (as for so many other national trends) in the state of California. The state has a history of failing to establish a budget and so, on several occasions, has paid certain creditors in IOUs. To date, California has paid its debts in full, but distributed IOUs to its employees and suppliers. Indeed a secondary market developed in which IOUs could be sold for cash at a discount.
In the same way, if the debt ceiling is not raised, the federal government can buy some more time by distributing IOUs to its employees and lots of large contractors in addition to doing something that California has not done: Paying some of its interest obligations in IOUs. I imagine that the Treasury is already in discussion with the central banks and sovereign wealth funds that hold a lot of our debt to arrange acceptance of deferred interest.
In addition, the Federal Reserve owns a very large portion of the outstanding Treasury bonds, and its interest income goes back to the Treasury in any case. If the political will to raise the debt ceiling is not present, then the federal government could probably buy itself a couple more months of positive cash flow, at least, by these means.
However, while that strategy would keep cash flowing, it would not, we conjecture, prevent the market from reacting badly. Although we are confident that investors would believe accrued interest would eventually be paid, they might be prompted to wonder just how well the American process of government functions – and whether its dysfunctionality could push the economy back into recession.
If the worst were to happen – the debt ceiling is not lifted – our view of the immediate consequences would include:
• Ratings downgrades.
• Movement out of long-dated bonds and, very likely, bonds all along the curve, including the short end that the Fed is still controlling.
• A possible last-ditch attempt by the Fed to buy longer-dated bonds to contain rising interest rates – an effort that could actually prompt fears of inflation and accelerate bond sales.
• Falling consumer confidence and rising interest rates that could further dampen the economy, increase unemployment, and prompt investors to flee US assets and the dollar. Historically, Treasury bonds and the dollar were safe havens. Under this scenario, they would not look quite so safe.
• Where would the money go? For reasons to be offered below, it is unlikely to flow to the euro or the yen. So we would anticipate a rush into the Swiss franc, the Canadian and Australian dollars, and a variety of emerging currencies, equity markets and commodities as well as into precious metals.
Why would the money not flow to the euro? That currency, as most newspaper readers can attest, holds little allure. Should the unprecedented occur, a looming crisis in the US could be matched by another crisis in the euro zone. Up to now, money has been flowing from the euro to the dollar rather than in the other direction. European politicians are as far-sighted and willing to compromise for the greater good as are our own. And the yen? Well, the Japanese government is far more indebted than is ours and presides incompetently over an even-slower-growing economy. There is a chance, indeed, that a fiscal crisis in the US would trigger one in Japan.
George Feiger is chief executive officer of Contango Capital Advisors, the wealth management arm of Zions Bancorporation (www.contangoadvisors.com).
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