What Happens If The US Defaults?

| July 25, 2011 | 0 Comments

The debate in Washington over raising the debt ceiling took a nasty turn at the end of last week.

Speaker of the House, John Boehner, walked out of negotiations on Friday.  Apparently, the White House tried to slip in another $400 billion in tax increases at the last minute.  (Republicans had already proposed increasing taxes by a whopping $800 billion!)

And the Democrat controlled Senate used a procedural maneuver to kill the House approved Cut, Cap, and Balance Act without a real vote.

These events sent tempers flaring on both sides of the aisle.

Never one to miss an opportunity to chastise Republicans, President Obama then held a carefully contrived Town Hall Meeting at the University of Maryland.

Before a packed house of supporters, the President went off on Republicans.  In a fit of self-righteous indignation, Obama accused Republicans of single-handedly pushing the country to the brink of doing the unthinkable… defaulting on our debt.

Never mind the White House and Democrats haven’t proposed a solution of their own for resolving the debt ceiling crisis.  That’s right, the only two solutions on the table right now were proposed by Republicans.

But hey, why propose a serious solution to a potentially catastrophic problem when you can use the issue to smear your political opponents, right Mr. President?

Things certainly looked bleak for the US on Friday night.  However, all is not lost.  There’s still time for both sides to reach a compromise by the August 2nd deadline for raising the debt limit.  (We have eight more days after all!)

Unfortunately, with both sides digging in their heels, the likelihood of the US defaulting on its debt has certainly increased.  And the heightened possibility of a default is sending shockwaves through the markets.

This raises an important question for investors.  What will happen to the markets if the US does default?

The short answer is nobody really knows exactly how markets will react.  A default of this kind has never happened before in the US.  However, it’s pretty clear how a default would generally impact various types of investments.

First off, interest rates on US Treasury bonds would almost certainly surge higher.  This is not what the fragile US economic recovery needs right now.  Higher rates would raise everyone’s cost of borrowing and likely stifle economic growth.

You see, Treasury rates are used as a baseline for just about every kind of interest rate.  In other words, higher Treasury rates would make it more expensive for ordinary Americans to take out a mortgage or get financing for consumer purchases.  And they would drive up the cost for corporations to get loans needed to expand their businesses.

What’s more, we’d likely see stocks, bonds, and the US Dollar plunge in value.  These types of investments don’t perform well when investors fear a major slowdown in economic growth.  Investors tend to pull their money out in times of crisis and move it into traditional safe-haven investments.

What qualifies as a safe-haven investment?

The most popular one right now is Gold.  Over the past several years, Gold has been the safe-haven of choice in times of crisis.  And recently we’ve seen Gold surge to all time highs.  With the other two usual safe-havens – Treasuries and the Dollar – poised to plunge, Gold will probably see even more crisis-buying than usual.

So, what should an investor do?

Let may say up front, I don’t think it makes sense to liquidate your stocks and bonds and move all in on Gold.  While the prospect of a default is frightening, I don’t think it’s going to happen.

Sure, we’ll see some heightened volatility in the days ahead.  But, in the end, there’s just too much at stake to allow a default to happen.

I’m confident our elected officials will find a solution… although we may come down to the wire before an agreement is reached.  Not because I have faith in our public servants to do the right thing.  No, there’s a better reason than the public good.

The fact is it’s in every politician’s best interest to avoid default.  No matter how much they might bluster, the President and Congress both know their political futures are toast if they allow the government to default.  And nothing drives a politician to act like fear of losing the next election.

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Category: Stocks

About the Author ()

Robert Morris is the editor of Penny Stock All-Stars, an investment advisory focused on discovering small-cap and micro-cap stocks that are destined to become the market’s next Blue Chips. The Wall Street veteran and small-cap stock specialist is also a regular contributor to Penny Stock Research. Every week, Robert shares his thoughts with our readers on a variety of penny stock-related topics. In addition to Penny Stock Research, Robert also writes frequently for two other free financial e-letters, ETF Trading Research and the Dynamic Wealth Report. He’s also the editor of two highly successful and popular investment advisories, Biotech SuperTrader and China Stock Insider.

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