Will the United States Default?


Our political madness is the lead media story every day, and the default-related technicalities and prospects have been thoroughly discussed. Despite the emphasis, the financial markets do not seem worried. The S&P 500 is within 1% of its all-time high. The 10-year U.S. Treasury bond yields just 2.69% -- hardly a punitive rate.

We see the odds of a timely increase in the debt ceiling, and therefore an avoidance of default, at greater than 95%. The U.S. dollar is the primary currency held in central-bank vaults around the world and is the primary currency of global trade -- collectively referred to by some economists as America's "exorbitant privilege". A default would surely shrink this privilege, and it could cost our economy far more than all items at the center of the congressional debate. We also saw Congress briefly hesitate to take action during the 2008 financial crisis, but the severity of the market's reaction induced a rapid response. It's hard to see default as anything but highly improbable and, in the worst case, a very temporary condition. 

An imminently approaching default, and certainly an actual, even momentary default, could cause significant volatility in the markets. With a quick resolution, however, we believe most markets would promptly return to previous levels. Compared with other recent moments of extreme market movement, this one is based solely on political unwillingness, rather than on a huge fundamental fault (e.g., lousy tech companies with outrageous valuations in 1999; wild lending standards, crazy-low yields, and heavy bank leverage in 2008). Again, if the markets were really concerned about our ability or willingness to pay our debts, our 10-year Treasury bond would NOT yield just 2.69%!

Since we expect little net effect from the debt-ceiling issue, and since we believe no one is skilled in the prediction of day-to-day market gyrations, we plan to maintain your portfolio's typically calm stance. As always, we watch the options market for affordable opportunities to hedge unusual risks and protect your portfolio at reasonable cost, but we do not plan to use options at the moment.

It may be that bondholders around the world begin to charge the U.S. Treasury a (marginally) higher interest rate in the future, but we believe that will be the case regardless of the path our Congress takes to raising the debt ceiling. The world is already watching, and our process must be creating greater lending reservations every day. Even if this issue causes bondholders to demand higher rates from the U.S. Treasury, this does not affect our outlook for your portfolio. We believe your portfolio is well positioned for increasing rates, whether resulting from political theater or the more fundamental factors we monitor (i.e., inflation and real interest rates).

In the investment classic The Intelligent Investor, Ben Graham said, "In the short run, the market is a voting machine, but in the long run it is a weighing machine." In managing your portfolio, we always look past the market's daily yeas and nays, and instead focus on the number on the scale, which weighs the fundamentally driven, long-term values of your securities. 

















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