We're in the dog days of summer, but traders and hedge fund managers will have to put off their retreat to the Hamptons until later. This year, several unanswered questions hang over global financial markets like a sword of Damocles -- none perhaps more pressing than whether or not Congress will raise the federal debt ceiling by early August. If not, the U.S. will risk defaulting on its obligations.
U.S. Treasury bonds are the global risk-free benchmark; anything that unsettles markets' faith in that assumption -- even if it is only a technical default -- could create tremendous instability in an environment that looks highly vulnerable.
To consider the odds of that event, I asked two of the Fool's best "big picture" analysts, Morgan Housel and Dan Caplinger, to answer the question that is at the forefront of the markets' collective mind: Will the U.S. lose its AAA rating?
Morgan Housel: The history of countries defaulting makes it clear that they are political events, not economic ones. Countries default by choice when it becomes the least-bad option, not when the markets force their hand. If the U.S. does default, it will almost certainly be caused by something like the debt ceiling getting in the way.
That said, the odds are overwhelming that the ceiling will be raised. I don't think anyone actually believes there will be a default in the near future. If a vote doesn't raise the ceiling over the next week or two and the market starts getting suspicious, bam, that's when you'll see Congress act. Remember the fall of 2008, when Congress was debating the TARP bailout package? The first vote failed, and the Dow immediately fell almost 800 points, at which time politicians changed their minds and quickly passed the bailout. Something similar might happen this time. All it takes is one rumor that default risk is putting Citigroup (NYSE: C ) or Bank of America (NYSE: BAC ) in dire straits for the market to nosedive, and you'll probably see a deal cut that day. It's in nobody's best interest for the Treasury to default.
Dan Caplinger: Any time politics gets involved in an economic decision, it's impossible to say what will or won't happen with certainty -- no matter how catastrophic the consequences might be. The idea that a debtor nation that owes more than $14.3 trillion in outstanding public debt would voluntarily take steps to sabotage its own credit rating and thereby increase borrowing costs not only for itself but for every U.S.-dollar borrower in the world is preposterous.
Even if the U.S. does have a technical default, I don't anticipate investors having to worry about never getting paid. The likely worst case would be similar to what happened in California in 2009, where the state ran out of money and creditors received IOUs at fairly attractive interest rates. At first, big banks including Wells Fargo (NYSE: WFC ) , Citigroup, and JPMorgan Chase (NYSE: JPM ) even accepted the IOUs in lieu of cash, although later, they reversed that decision and stopped accepting them amid concerns about fraud.
Of course, the statutory debt ceiling doesn't allow IOUs, but it would be easy to pass legislation setting an interest rate for past-due Treasury debt. That might even lead to the creation of special markets for defaulted debt, just as Wall Street firms considered trading California IOUs two years ago. It will certainly get the message across to lawmakers that a default isn't worth the cost.
Alex Dumortier: I still think the odds of a U.S. default remain very low -- less than 2%, if I had to guess. However, that number is fundamentally unknowable, since the outcome is the product of human affairs. If people were rational, there'd be a degree of predictability to their actions, but it's difficult to make that case concerning our political leadership when one observes the spectacle on display in Washington. It's truly a case of the inmates running the asylum! Indeed, some of the lunatics are behaving as if a default is desirable.
Given the level of uncertainty this is creating, it's no surprise that different markets appear to be assessing the risk of default differently. The bond market, on the one hand, doesn't look one bit concerned, with the 10-year Treasury bond yielding 2.90%, near its 2011 low. Meanwhile, gold achieved another all-time (nominal) high on Monday, breaking $1,600 for the first time. Another precious metal, silver, has also gained strength recently, with the iShares Silver Trust (NYSE: SLV ) up 16% since the beginning of the month.
My hope is that the Treasury bond market has a better read on the situation than precious metal buyers.