The Debt Ceiling Dispute Raises the Risks for ‘Risk-Free’ U.S. Bonds
It’s come to this.
Because of the debt ceiling crisis, a corner of the financial markets sees the U.S. governmentas a riskier borrower over the next month or so than Bulgaria, Croatia, Greece, Mexico, the Philippines and a host of other countries that have never been remotely considered linchpins for the modern global financial system.
Don’t get me wrong. I hold Treasuries in my personal portfolio and, with one noteworthy exception, there is no sign so far that investors around the world are abandoning Treasuries — or the U.S. dollar or the U.S. stock market, for that matter. The United States is the core of world finance, and I expect that it will remain so.
Yet an important but often overlooked sector of financial markets — the $30 trillion market for credit default swaps — says that the debt ceiling standoff is truly serious. Short-term costs for insurance against a U.S. debt default are soaring right now.
What’s more, there are indications that Washington’s periodic flirtations with debt default are already having subtle negative long-term effects in global markets.
Janet L. Yellen, the Treasury secretary, has said that if a U.S. debt default happens, it will be “economic and financial catastrophe that will be of our own making.” All catastrophes have costs, and the markets are struggling to assess them.
President Biden has begun discussing the debt ceiling with Speaker 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 bump into the debt ceiling sometime in June. If Congress doesn’t act by then, the United States could run out of money. It’s conceivable that it will stop paying its bills, including millions of Social Security checks, and that it could default on its debt for the first time.
The stock market has been focused on other matters — 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 more than a year. But if there is no resolution of the debt ceiling dispute until the last minute, a sharp decline in the stock market would not be surprising. That’s happened before, even without an actual default. Eventually, the stock market recovered.
Treasuries are normally viewed as the safest investments. But now, one-month Treasury bills due in June are being seen in the markets as potential trouble spots. Their yields have shot up over the last week or two, pushing them higher than the yields for two- and three-month bills. That’s not typical.
In two or three months, the logic goes, the debt ceiling crisis will be behind us. In the meantime, 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 averted and, at current prices, one-month Treasury bills are bargains.
They may well be, but that’s only because they are deemed risky. Yet Treasuries are supposed to be risk-free assets. Virtually all financial assets on the planet are priced in relation to Treasuries, so you could argue that if the U.S. Treasury defaulted, there would be nowhere safe to go. Under these circumstances, it’s difficult to assess the safety of anything in the financial world.
Short-term Treasuries aren’t the only asset class directly affected by the U.S. debt ceiling. Worries have also crystallized in the credit default swaps market. This is an arena for deep-pocketed institutional investors — hedge funds, banks, pension funds and the like — and not a place that I usually spend a lot of time thinking about. But credit default swaps provide insight about the gratuitous damage that the political dysfunction in Washington is inflicting on the credit of the United States.
Consider that credit default swaps are essentially insurance. For a defined period, investors can obtain protection against losses from a debt default by a corporation or a government. The United States remains the world’s financial powerhouse. But until 2011, it also was in a select group of countries with the world’s highest credit rating. That year, though, Standard & Poor’s lowered its credit rating one notch because of the debt ceiling debacle.
Germany, on the other hand, still has a pristine, triple A credit rating. Although it doesn’t have the clout of the United States, it’s not surprising that Germany is deemed a better credit risk. But the extent to which that is now true is astonishing.
“Look at the credit default swaps market and you get a sense of how much the United States is being hurt by these debt ceiling crises,” said Richard Bernstein, a former chief investment strategist at the old Merrill Lynch who runs his own firm, Richard Bernstein Advisors.
I looked. While the probability of an actual debt default is still low, the cost of insurance for U.S. bonds over the next 12 months was about 50 times the price for Germany and about three to seven times that of countries like Bulgaria, Croatia, Greece, Mexico and the Philippines. That’s according to FactSet data. Over longer periods — three, five and 10 years — the cost of insuring against a U.S. default drops.
As you would expect, over longer periods, the United States is deemed safer than countries with weaker credit ratings, but it’s still about three times more expensive to insure U.S. debt than it is for Germany. And the yields on German sovereign bonds are generally lower than those for Treasuries, Mr. Bernstein pointed out. There are many reasons for this, but one important one is the safety of German debt. “Even when they are resolved, these debt crises are putting the United States at a long-term competitive disadvantage,” he said.
A Longer View
In his latest annual letter to the shareholders of Berkshire Hathaway, Warren Buffett wrote of 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 made sense to make a long-term bet against America,” he said.
I share that optimism, but I confess I’m worried. The debt ceiling crisis is a symptom of political dysfunction. Bizarrely, the United States has the ability to pay its debts but may not do so because of an inability achieve a political consensus.
So what is to be done?
Like Mr. Buffett, I believe most people should invest for the long haul, using low-cost index funds. But I’m not entirely confident that the United States will act in its own best interests. So, unlike Mr. Buffett, I believe investors should hold stocks and bonds from the entire world, not just the United States. I’m hedging my bets, long- and short-term.
For the next month or two, I’m bolstering my stash of relatively safe cash holdings in government money market funds and federally insured savings accounts. No option will be entirely safe if the United States defaults, but I don’t see better alternatives.
That’s the odd thing. In a crisis, even one caused by the United States, investors tend to seek a haven in Treasuries. That happened in 2011, and it’s likely to keep happening, unless and until the United States finally loses its luster.
For now, be careful with your own money — and hope that your elected officials preserve the full faith and credit of the United States.