Where is the safest place to have money if the U.S. Treasury defaults on its debt?
Where is the safest place to have money if the U.S. Treasury defaults on its debt?
By John H. Robinson, May 24, 2023
I cannot believe we are actually having this conversation, but we are. Over the past few months, the topic of the debt debt-ceiling has increasingly come up in client communications. Over the past week or so, it has been the topic of nearly every client conversation.
In February, I posted an article to our blog titled, “What if the U.S. Treasury Defaults on its Debt?”. In the article, I expressed my view that, while the current juvenile political brinksmanship does nothing but harm the credibility of the U.S. and unnerve its citizens, at the end of the day, there is very little concern because, “even the most dysfunctional Congress will not be foolish enough to let our cachet as the world’s safest investment haven evaporate.” Although the potential cost of default is difficult to quantify, whatever that cost may be, it is widely accepted that it would be “catastrophic.” As President Biden expressed in a speech last week, “Every leader in the room understands the consequences if we fail to pay our bills. The nation has never defaulted on its debt, and it never will.”
The Stupidest Game of Chicken Ever
Fast-forward to today, and I confess that my confidence that rational minds will prevail is waning. Both political parties appear to be controlled by their respective extremes. In a rational world governed by leaders with an emotional maturity level above that of a toddler, there would simply be an unencumbered, unrestricted bill to raise the debt ceiling (as in other countries) that would unanimously pass in the House and Senate. Instead, we have one party fixated on attaching spending cuts to the agreement and the other fixated on raising taxes.
Both parties are effectively threatening the other by holding a gun to their own heads. It truly is the stupidest game of chicken ever, but the more I listen to the rhetoric coming out of both parties, the more it seems that our congressmen may really be that stupidly partisan. If the U.S. really does default, even temporarily, even the most optimistic projections of the fallout are dire. It is difficult to imagine how ANY of the clowns in office during this fiasco could escape with their political lives, but, as anyone who has ever tried to calm an angry 3-year-old can attest, rationality does not always prevail.
What Should Investors Do to Protect Against the Possibility of a Default?
How’s this for unambiguous guidance? -
If you have money in U.S. government money market funds, U.S. Treasury money market funds, or treasury bills maturing in June or July SELL those securities and hold cash deposits or perhaps even prime money market funds until the debt ceiling crisis is over.
The views expressed in my February blog post were well-reasoned, and I still believe that the possibility of a default is low. Anyone who has taken a college-level finance or macro-economic economics course may recall that the yield on treasury bills is referred to as the “risk-free” rate. R-I-S-K F-R-E-E. My guidance has always been driven by the presumed truism that there is no safer asset on the planet. Similarly, the corollary of this truism is that if treasury bills default, there is no other asset class that would provide shelter.
Given that the treasury market is the largest debt market (by far) in the world and that it is the backbone of the global financial system, I have never had any reason to think that the “full faith and credit of the U.S. government” was anything less risk-free. For as long as I have been around any time there has been an exogenous shock the to global economy or financial markets, the term “flight to safety” is consistently used to describe the rush by panicking investors to buy treasuries.
However, something strange has been going on in the bond markets over the past couple of weeks that has caused me to put on my critical thinking cap. First, there has been a dramatic spike in the yield of treasury bills maturing from June through August that cannot be explained merely by an inverted yield curve. The only logical explanation for this is that investors perceive there is at least some real possibility of default and that the yield differential represents current the risk premium.
Although these T-bills are far from trading like junk bonds, another peculiar consideration is that the yields on certain short-term AAA-rated corporate bonds are lower than T-bills of the same maturities. It seems that investors perceive there to be less risk in these bonds than in treasuries. That is shocking. But it is a real phenomenon, and it would be foolish to ignore it.
Over the past few weeks, I have read a few articles suggesting that bank accounts are somehow safer than treasuries because “treasuries are not insured” while bank deposits are FDIC. On the surface, that reasoning is naïve and uninformed. The only reason FDIC has any credibility is that its deposits are backed by the “full faith and credit of the U.S. Government” (i.e., the Treasury). Treasury securities don’t need FDIC coverage because they are literally issued by the Treasury. However, as a practical matter, your bank does not necessarily need to rely on FDIC to maintain its daily liquidity so it is entirely possible that a default on treasuries might not have any immediate effect on bank deposits unless the treasury default triggers a run on banks too.
For all of these reasons, my best advice for the last week of May is the sell guidance highlighted above and to temporarily park the proceeds in bank deposits and/or prime money market funds.
Critical Thinking and Accountability
For the record, I am 100% aware that I have been outspoken over the past year in encouraging clients to take money out of low/no interest bank deposits and reallocating to T-bills and/or treasury money market funds with state tax-free yields in the 4.5-5.0% range. I have been encouraging clients to purchase treasury money market funds with their liquid cash as recently as last week.
I learned a long time ago that ego is a horrible and potentially career-ending reason to blindly stand by an investment recommendation. Accountability, on the other hand, is a valid reason for changing course. While I still believe there is a very low probability of a Treasury default, I see very little downside to taking money out of short-term treasuries for a month or two. Conversely, given that nearly all our clients’ money that is in short-term treasuries represents their “safe money,” the cost of not side-stepping this potential calamity is potentially severe. With respect to accountability, I believe FPH clients will appreciate our erring on the side of extreme caution.
It is also worth mentioning that comments yesterday by Treasury Secretary Janet Yellen are what inspired me to make this recommendation and write this post. For months, Yellen, along with scores of other esteemed economists have been warning that the fallout from even a temporary default would be “catastrophic” (that is the term that keeps cropping up). Yesterday, when Ms. Yellen was asked to quantify the risk from a default, her response was, “[The] Treasury is not involved in planning with investors for a default.” Translation: “Ask your barber, because I have no freaking clue.”
I do not know if my suggested actions will be sufficient to avoid the fallout from a default, but the change recommendations are based on critical thinking given the conditions and information at hand. For information in support of this guidance, I encourage you to read four articles that helped shape my thinking. Links to the articles along with key excerpts from each are included below as “RELATED READING.”
In closing, there are two other common questions that have come up over the past couple of weeks that I am compelled to address:
Should I/we Sell our stocks and/or mutual funds/ETFs?
That is a hard NO. I do not disagree that the stock market may tank in response to a default. However, stock market timing decisions require getting two very tricky decisions right – when to get out and when to get back in. Given that the market is remarkably efficient at pricing risk at any given moment in time, rarely do investors get both of these decisions right. In my experience, most investors who try their hand at market timing tend to sell on the way down and buy back at a higher price when the recovery is well under way.
Additionally, it is understood that the stock market represents the volatile long-term portion of investors' portfolios. It is not where investors park their short-term safe money. We fully expect and plan for significant downturns in the stock market. Over the past 30 years, I have worked through several major market declines including two prolonged bear markets that saw the S&P 500 Index decline more than 50%. It has always come back because it is made of real companies that earn real profits. If financial Armageddon results in the failure of all publicly traded companies, I submit that our portfolio values will be the least of our worries.
Should I/w Buy Bitcoin, gold, and/or foreign currencies to hedge Treasury default risk?
Again, this is a hard NO. All these assets (though I don’t consider cryptocurrency, including Bitcoin to be a legitimate asset class) are volatile in nature and are not a substitute for a safe, stable fixed-income investment.
In theory, if U.S. government bonds aren't safe, then nothing is safe. Treasuries are what people buy when they want zero risk. However, assets do exist that can be considered safer than Treasury bonds, at least in the short term.
Money market funds that invest in Treasuries - money funds invest in high-quality, liquid, short-term debt, including Treasuries, government agency debt and corporate securities - are also avoiding exposure to Treasury bills that mature in June, said Crane. "That's the sort of kryptonite that people are staying away from," he said.
…when this [debt ceiling] issue arose in 2011, the Obama Treasury was planning to make all interest and principal payments and to delay paying all its other bills—including government benefits. The Biden Treasury hasn’t said what it plans to do if Congress doesn’t raise the debt ceiling in time. It is, however, likely to make interest and principal payments on Treasury debt. Whether and how it will prioritize other payments is unclear—but someone will not get paid on time; there simply won’t be enough cash to meet every obligation
The $24 trillion U.S. Treasury market is the primary source of financing for the government as well as the largest debt market in the world. The Treasury market is the backbone of the financial system, integral to everything from mortgage rates to the dollar, the most widely used currency in the world. At times, Treasury debt is even treated as the equivalent of cash because of the surety of the government’s creditworthiness. Shattering confidence in such a deeply embedded market would have effects that are hard to quantify. Most agree, however, that a default would be “catastrophic,” said Calvin Norris, a portfolio manager and interest rate strategist at Aegon Asset Management. “That would be a horror scenario.”
These potential costs — unknowable in total but widely thought to be enormous — are what many believe will motivate lawmakers to reach a deal on the debt limit. “Every leader in the room understands the consequences if we fail to pay our bills,” President Biden said in a speech on Wednesday, as negotiations between Democrats and Republicans intensified. “The nation has never defaulted on its debt, and it never will.”
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