Potential default on US sovereign debt grows nearer

Today’s Commentary

Summary: According to press accounts, the Senate could vote on a plan to end the government shutdown and avert a default on U.S. government debt as soon as tonight. Nonetheless, we are clearly in the 11th hour and must consider default a real possibility.

When I wrote last about the debt ceiling crisis in the U.S., I wrote of my concern that a US sovereign default would lead to a catastrophe of unknown proportions and that the U.S. was headed in this direction. Frankly, little has changed since then in terms of the basic tactical strategies to avert default and we have to believe a serious policy error is possible, one that ends in economic Armageddon. My understanding is that though the debt ceiling will be breached around Thursday, we are in a period in which for a few days the U.S. government is taking in more money than it spends and that gives us a few more days leeway. But all of this is uncertain for me as it is for Congress, meaning that the mere fact that we are still here at this late date shows us that default can indeed occur.

The deal now being cobbled together in the senate comprises an increase in the debt ceiling through February 7th only via extraordinary measures, a budget framework by Dec 13th and a compromise on Obamacare requiring income verification. This deal will pass the Senate but may not pass the house as the house was unable to vote on its own separate deal because the Republicans did not have enough votes within their own party to get the bill through. Meanwhile, Fitch has warned it is prepared to downgrade U.S. sovereign debt and has put the U.S. on negative credit watch.

There really isn’t much more to be said at this point. The U.S. political system has completely broken down. And while we may get through this episode, I believe we are destined for more such episodes until either those creating these crises are voted out of office or the U.S. defaults and the economy slips into recession. From an investing perspective, now is the time to start putting on those expensive hedges. Unfortunately, you have to make the move because not doing so could be a serious risk to your portfolio. You want to be long volatility but short risk. That probably means overweight U.S. T-notes, underweight stocks and high yield.