U.S. Default Could Be A Disaster

On September 30th, the United States Congress sent a bill to President Biden's desk to avoid a government shutdown, at least until December 3rd. In the past, when the government has shut down or come close to a shutdown, similar to what just happened, we have seen market turmoil caused by the uncertainty surrounding the situation. However, even with that uncertainty removed temporarily until December 3rd, the markets may not have much breathing room since lawmakers still need to raise or suspend the debt ceiling before October 18th.

If the politicians in Washington can't agree on the debt ceiling, the U.S. could default on U.S. debt, something that most market participants believe would be "disastrous." However, the United States has never in its history defaulted on government debt. So, we honestly do not know what would happen if it were to happen. But, since U.S. Treasury bonds are widely considered "zero" risk and used as a benchmark or starting point to determine the risk of other alternative investment options if the government did indeed default, it would send shock waves throughout the market as other assets would need to be repriced based on their risk level when compared to U.S. Treasury bonds.

The uncertainty which would follow and potentially dramatic rise in interest rates across the board could and very likely would send the U.S. economy into a tailspin with the stock market falling and potentially a rise in unemployment. Some even believe that government spending in the forms of social security payments and bills owed to contractors would be suspended for a period of time while the U.S. Treasury determines what to pay and what not to pay. This would obviously hurt the overall economy as potentially millions of Americans would not receive social security checks and or paychecks if they work for a government contractor.

However, the long-term implications of defaulting would likely be the worst consequences. It is estimated that the U.S. Government gets a 25-basis point reduction in its interest rate because of the 'perceived unparalleled safety and liquidity of the Treasury market.' That discount on interest rates the government receives equates to roughly $60 billion in lower interest payments this year alone and more than $700 billion in interest savings over the next decade, based on the current U.S. debt amount. That means if the politicians in Washington can't agree on something and the U.S. Treasury Department is forced to come up with creative solutions because it doesn't have the funds to pay its bills, the U.S. taxpayer will be on the hook for a higher interest rate in the future.

So as an investor, how should you proceed over the next few days or weeks as this plays out?

Let's talk about a few options you have at your disposal.

First, do nothing different and maintain the mindset that 'this storm will pass.' This is honestly the mindset that 99% of investors should take. If the stock market crash at the start of the pandemic, or the 2007-08 financial crisis, or the dotcom bubble (I'll stop here), have taught us anything, it's that the market will rebound and go higher than it was even just prior to the crisis. Long-term-oriented investors should literally just sit back and ride the roller coaster with their hands up (screaming is allowed but only in the confines of your own home) and let the market do what the market does. There is absolutely nothing wrong with this approach; you just need to be patient and keep a calm mind if the mayhem does hit.

Another option is that you could buy the market now, prior to the potential market-crushing event, with the thinking that some stocks have already been taken lower by some investors in anticipation of a big drop that they don't want to be involved in. Then when the potential future market wrecking event doesn't happen, stocks will bounce higher, and you will be sitting pretty. Finally, you could buy individual equities or ETFs that mimic the market, such as the Vanguard S&P 500 ETF (VOO), the SPDR S&P 500 ETF (SPY), which both follow the S&P 500 Index or the Invesco QQQ Trust (QQQ), which tracks the NASDAQ Index.

A third option is to buy a hedge in case the ceiling is hit, and we don't have a solution from Congress, and the markets go haywire. Again, you would remain stable and hold all your current holdings and make no changes to those either before or after the crash occurred. However, before the crash, you hedge your long-term holdings and buy something like the Direxion Daily S&P 500 Bear 3X Shares ETF (SPXS), which is betting that the S&P 500 will go lower, or the ProShares UltraPro Short QQQ (SQQQ), which is an ETF that is betting against the NASDAQ Index or the QQQs. Another way of hedging would be to buy put options on the Vanguard S&P 500 ETF or the Invesco QQQ Trust themselves.

As I said before, 99% of investors should just sit back and watch the mess play out in Washington and do nothing different with their investors or portfolio. The 1% that may want to 'time' the market have a 50% chance of being right, so good luck. But what 100% of investors should do, is keep investing, no matter what happens over the next few weeks.

Matt Thalman
INO.com Contributor - ETFs
Follow me on Twitter @mthalman5513

Disclosure: This contributor did not own shares of any investment mentioned above at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.

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