Investor, get ready for the possible American default that is coming! With the approaching debt limit of the United States government and the potentially catastrophic consequences that may follow, investors around the world are seeking ways to protect their investment portfolios. In this article, we will discuss the possible scenarios resulting from this situation and present strategies that investors can consider to protect themselves against the risks associated with the debt ceiling.
Prepare for the American Default!
If Congress does not agree to raise the debt ceiling by early June or at least grant a temporary extension, the United States government may face the possibility of defaulting on its debt or be forced to implement significant spending cuts.
While a default is unlikely to occur, such a scenario would have severe consequences not only on the economy but also on the financial markets, both in the short and long term.
To mitigate these risks, it is advisable to avoid using leverage, ensure that your investment portfolio is diversified, and if you desire more effective protection, consider buying stock volatility or put options on stocks or an index.
The United States is facing a crisis, with the country’s debt reaching the maximum limit of the “debt ceiling.” While there is a reasonable probability of avoiding the worst-case scenario, there is still the possibility, as well as several imperfect alternatives. In any case, it is important to be prepared for what may happen. Therefore, we will address what the debt ceiling is, why it is relevant to investors at the moment, and the impact of each governmental solution on the markets and your investment portfolio.
What is DEFAULT?
Default is a term used to describe the situation in which a bond issuer, such as a government or company, fails to meet its payment obligations to investors. This can occur when the issuer does not have sufficient financial resources to make interest payments or repay the principal amount of the investment. In other words, it is when the debtor fails to honor the agreement made with investors. Default is considered a negative event as it can result in financial losses for investors who have entrusted their money to the issuer.
What is the debt ceiling? If you have a credit card, you probably know that it has a spending limit, which determines the maximum amount you can borrow. In the United States, the government has something similar called the “debt ceiling” – although with a slightly higher limit of $31.381 trillion, about one and a half times the size of the country’s economy. This limit is set by Congress, which has the power to raise it if necessary.
The reason why the United States government needs to borrow is that it spends more than it collects in taxes and other revenues. After all, financing initiatives such as social security, Medicaid, the military, education, and transportation is definitely not cheap. To cover these expenses, the government issues debts in the form of Treasury bonds and obligations. However, this is not a simple solution: the government needs to pay a considerable amount of interest just to deal with its existing debt.
The debt ceiling exists to hold the government accountable for its financial decisions and allow politicians, investors, and observers to track the government’s excessive spending. Rightfully so, as it has been proven that excessive spending can have negative effects, such as slowing down economic growth, increasing interest rates, and reducing the government’s ability to respond to economic crises. Additionally, when the debt is considered too high, investors may lose confidence in the government’s ability to fulfill its interest payments.
What is the concern?
Uncle Sam, the big spender, hit the limit on his credit card back in January this year. Since then, the government has resorted to “extraordinary measures” – also known as accounting tricks – and has been using its reserves to pay the bills. But time is running out, and it’s possible that all contingency options will be exhausted by June, although the exact date depends on the amount of taxes collected by the government until then.
Therefore, unless Congress agrees to raise the debt ceiling, or at least grant a temporary extension, the government will face the risk of defaulting on its debt or be forced to implement severe spending cuts. At that point, the situation could become really serious, quickly. A partial government shutdown would result in disruptions and delays, and any suspension of payments, such as social security, Medicaid, and military salaries, would affect millions of Americans.
The potential economic impact would be significant. The government could be forced to cut payments by about 10% of the economy, which would lead to an even greater decline in the already unstable growth, with a high single-digit decrease in the case of a prolonged default and over one percent in the case of a short-term default. This would virtually guarantee a recession. Furthermore, it could have long-term effects such as undermining the position of the US dollar as the world’s primary reserve currency and hampering the government’s ability to respond to future economic crises or invest in essential public services and infrastructure.
However, the most significant impact could be on the financial aspect. Non-payment of debts could lead investors to seriously question the solvency of the government – as happened when the US lost its AAA rating during the previous standoff in 2011. This doubt would cause turbulence in the financing markets, which are crucial for the funding of important institutions, and increase volatility in virtually all other markets. Given today’s extremely uncertain macroeconomic environment, with already high interest rates and political tensions, price fluctuations may be even more pronounced than investors expect.
How likely is this scenario?
Although the risk of a catastrophic scenario seems high, it is likely that we will avoid this disaster. The consequences would simply be too severe. Therefore, it is more likely that the debt ceiling will eventually be raised, and the government will take temporary measures to deal with the situation, as has happened on several previous occasions.
However, the determining factor is time. The reason why the debt ceiling has not been raised yet is related to politics, in every sense of the word. Currently, the House of Representatives, which plays a crucial role in the legislative process, is under Republican control. The party can use its influence to delay any agreement by demanding significant spending cuts that align with their policies. However, so far, the Democrats have refused to participate in negotiations, which increases tension and creates a dangerous game of forces. While a prolonged default is unlikely to occur, tensions are likely to increase as we approach the deadline, with each party incentivized to exacerbate the issues to gain concessions from the other side. This makes a technical short-term default much more likely and significantly increases the risk of greater volatility in the coming weeks.
Now, there are other possibilities at play. Lawmakers could resort to a strategy known as a ‘discharge petition’ to bypass the need for the Speaker’s approval, although the chances of success are slim. A somewhat more likely scenario would be for Congress to buy time by passing a bill to temporarily suspend the debt limit for a few weeks or months. A more extreme and risky option would be for the President to create a $1 trillion coin, deposit it at the Federal Reserve, and use that money to pay for government expenses. So, the good news is that even without an agreement, there is no guarantee that the government will default on its debt, not even temporarily. However, we need to face reality: even if we avoid the worst-case scenario, the other options are unlikely to calm investors. The markets will likely remain volatile until a more convincing solution is found.
How can I protect my investment portfolio?
While a lack of resolution may seem unlikely, it is still a risk worth protecting against. Remember that the potential consequences can be enormous, so volatility is likely to remain high until the issue is adequately resolved. Some markets are already reflecting higher risks: investors now demand higher returns to justify the risk of holding securities maturing on the three most likely default dates, June, July, and October. Additionally, the cost of protection against a possible default by the United States government on its debt – through a derivative contract called a credit default swap (CDS) – has increased significantly. However, most markets seem to be underestimating the potential impact, with stock market volatility surprisingly stable so far.
If you have a truly long-term investment horizon and can handle short-term fluctuations, perhaps the best option is to do nothing – at least for now. However, if you want to reduce the risk of significant short-term losses, there are some options available.
First, make sure you are not overly leveraged or overly concentrated in a single investment theme. Ideally, you would have a well-diversified portfolio composed of different asset classes, sectors, and styles. Also, avoid selling options without a corresponding protection position, as this can result in significant losses if something unexpected happens.
If you are seeking specific protection regarding the debt ceiling, you may consider acquiring assets that are more likely to benefit from the tension. For example, investments like gold may attract investors seeking safe assets and given growing concerns about the U.S. dollar. Additionally, defensive currencies such as the Japanese yen and the Swiss franc tend to appreciate against the dollar.
For those seeking more comprehensive protection, it is possible to invest in stock market volatility, such as the VIX, an index that tracks market volatility, through an exchange-traded fund (ETF) or contract for difference (CFD). However, it is worth noting that this option can have significant costs over time. Another alternative is to purchase put options or spread strategies, where you buy and sell put options based on their exercise prices on stock indices. However, when choosing this approach, it is important to have a well-defined exit strategy, as profits can quickly turn into losses if an unexpected event occurs, leading to an increase in protection prices.
In the future, interesting buying opportunities may arise. After the resolution of concerns surrounding the debt ceiling, long-term bonds may appreciate as investors are likely to seek their relative safety.
However, it is essential not to underestimate the risks associated with the debt ceiling, regardless of the adopted strategy. While it is possible to hope for the best scenario, it is always prudent to prepare for the worst.
Although a resolution to the debt ceiling seems likely, it is important to recognize that the risks associated with this event should not be underestimated. Investors should be prepared to deal with the volatility and uncertainty that may arise in the coming months. From portfolio diversification and the adoption of protection strategies to the analysis of buying opportunities after the deadlock is resolved, there are measures that can be taken to mitigate the possible negative impacts. Stay abreast of developments related to the debt ceiling and adapt your investment strategies accordingly.