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Ok, let's face it... US public debt is high and people are starting to wonder if the country might default on its debts. How would this hit United States' stock market, its bonds, or its currency? What kind of securities would be more affected??

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This is a speculative question and there's no "correct" answer, but there are definitely some highly likely outcomes.

Let's assume that the United States defaults on it's debt. It can be guaranteed that it will lose its AAA rating. Although we don't know what it will drop to, we know it WILL be AA or lower.

A triple-A rating implies that the issuer will never default, so it can offer lower rates since there is a guarantee of safety there.People will demand a higher yield for the lower perceived security, so treasury yield will go up.

The US dollar, or at least forex rates, will almost certainly fall. Since US treasuries will no longer be a safe haven, the dollar will no longer be the safe currency it once was, and so the dollar will fall.

The US stock market (and international markets) will also have a strong fall because so many institutions, financial or otherwise, invest in treasuries so when treasuries tumble and the US loses triple-A, investments will be hurt and the tendency is for investors to overreact so it is almost guaranteed that the market will drop sharply.

Financial stocks and companies that invest in treasuries will be hurt the most. A notable exception is nations themselves. For example, China holds over $1 trillion in treasuries and a US default will hurt their value, but the Yuan will also appreciate with respect to the dollar. Thus, other nations will benefit and be hurt from a US default.

Now many people expect a double-dip recession - worse than the 08/09 crisis - if the US defaults. I count myself a member of this crowd. Nonetheless, we cannot say with certainty whether or not there will be another recession or even a depression - we can only say that a recession is a strong possibility.

So basically, let's pray that Washington gets its act together and raises the ceiling, or else we're in for bad times.

And lastly, a funny quote :)

I could end the deficit in 5 minutes. You just pass a law that says that anytime there is a deficit of more than 3% of GDP all sitting members of congress are ineligible for reelection. - Warren Buffett

  • Ahhh....socialist Warren. I have a quote for Warren: "I could end Berkshire Hathaway in 5 minutes....end federal bailouts." Berkshire purchased a large stake in Goldman Sachs and then Warren petitioned the US government for a bailout of the banking system. Using the words of Warren's buddy Charlie Munger: suck it up and cope Warren. – Muro Jul 11 '11 at 12:33
  • Thanks @AUpadhyay. My question might have been a bit speculative but I just opened and funded an IRA and I was a little worried about the current market stability. I'm new to investing and not sure how to build my portfolio in terms of percentage of equities vs fixed income securities (not sure which one would be the safest in this period). Maybe I should just be patient and wait a couple of weeks... – Gevorg Jul 12 '11 at 4:17
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    @Gevorg - Personally, I don't think a default will occur. As far as investing strategy goes, I suggest you read "Unconventional Success" by David Swensen. It's intended to teach asset allocation and investing to the individual investor, and it will help you build the proper investing mindset. – BlackJack Jul 12 '11 at 11:39
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The default scenario that we're talking about in the Summer of 2011 is a discretionary situation where the government refuses to borrow money over a certain level and thus becomes insolvent.

That's an important distinction, because the US has the best credit in the world and still carries enormous borrowing power -- so much so that the massive increases in borrowing over the last decade of war and malaise have not affected the nation's ability to borrow additional money.

From a personal finance point of view, my guess is that after the "drop dead date" disclosed by the Treasury, you'd have a period of chaos and increasing liquidity issues after government runs out of gimmicks like "borrowing" from various internal accounts and "selling" assets to government authorities.

I don't think the markets believe that the Democrats and Republicans are really willing to destroy the country. If they are, the market doesn't like surprises.

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Regarding the Summer of 2011 Crisis: There is NO reason that the United States cannot continue borrowing like it is just based on a particular ratio: Debt to GDP.

The Debt to GDP ratio right now is around 100%, or 1:1. This means the US GDP is around $14 Trillion and its debt is also around $14 trillion. Other countries have higher debt:gdp ratios

Japan - for instance - has a debt:gdp ratio of 220%

Regarding a selloff of stocks, dollars and bonds: you have to realize that selling pressure on the dollar will make THE PRICE OF EVERYTHING increase. So commodities and stocks will skyrocket proportionally.

The stockmarket can selloff faster than the dollar though.

And both markets have circuit breakers that can attempt to curb quick selloffs. Effectiveness pending.

  • "NO reason that the United States cannot continue borrowing like it is" There is actually a very good reason and it's called the "debt ceiling." The United States can't owe more than $14.294 trillion as it stands, regardless of how much the GDP is. Theoretical debt to GDP ratios can be debated all day long, but when it comes to the real world, policy matters. – BlackJack Jul 11 '11 at 3:48
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    Right, Congress mandates the debt ceiling. Congress is debating it because borrowing is unsustainable, Congress doesn't NEED to debate it today it can easily raise the debt ceiling yet again without consequence like during the ENTIRE PREVIOUS DECADE. The Unites States can EASILY defend its assets and access to resources as demonstrated in several military excursions into sovereign nations just this year. It is wise that they are considering cutbacks, but there is no reason for the political charades.Money is less relevant to military might, look at what happened to Monaco during WWII. – RD. Jul 11 '11 at 5:07
  • The main point is the security and safety of your money. The intricate policies are meant to avoid unrest and turmoil. But if push came to shove the United States can defend your assets, that is where the United States credit rating comes from. The fact that its historically been paying its bills on time is a perk. – RD. Jul 11 '11 at 18:52
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    Yes, the ceiling can be raised, its pure politics, there is no operational reason for the ceiling. I think fear mongering is an apt description. – Andy Wiesendanger Jul 12 '11 at 16:08

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