Brace for the Worst as Debt Ceiling Crisis Deadline Nears

If Washington lawmakers don't beat the debt ceiling crisis deadline, we'll see plummeting stocks, soaring interest rates, a slumping dollar and a severe shock to the weak economy.

All of which will hit you in the wallet – and hard.

Most investors are not prepared for the consequences of the failure of U.S. lawmakers to agree on a plan that will raise the federal debt ceiling before the Aug. 2 deadline.

Few believed it even possible, but with only a week to go Congressional leaders and U.S. President Barack Obama are no closer to a deal than they were several months ago.

"We may have a few stressful days coming up – stressful for the markets of the world and the American people," William M. Daley, President Obama's chief of staff, admitted on the CBS program Face the Nation on Sunday.

Until recently, the markets have kept a cool head – most analysts have assumed government officials would reach a compromise in time.

But when negotiations between President Obama and Speaker of the House John Boehner, R-OH, broke down over the weekend, the possibility of a U.S. default suddenly grew frighteningly real.

"There has been this expectation that at some point, they'd come up with a deal, but given the failure this weekend, I think market confidence is eroding," John Canavan, a market analyst at Stone & McCarthy Research, told The New York Times.

The impact of the endless political dithering is already being felt in the equity markets, which will become increasingly sensitive to developments in Washington as the clock ticks ever closer to the debt ceiling crisis deadline.

The Dow Jones Industrial Average dropped 145 points early yesterday (Monday) in reaction to the lack of progress over the weekend, although it recovered about half of the losses later in the session.

"The stock market is where a lot of the volatility will occur," Bernie Williams, vice president of discretionary money management at USAA, told USA Today.

Bonds Threatened

Perhaps more vulnerable, however, will be the bond markets.

All three major credit rating agencies – Moody's Investors Service (NYSE: MCO), Standard & Poor's and Fitch – have threatened to downgrade U.S. credit, which could cause a selloff in U.S. Treasurys, particularly the 30-year notes.

Ominously, the credit agencies have warned of a ratings downgrade not just in the case of a default, but also if Congress fails to address the amount of debt as well as the yawning budget deficits that feed it.

"When this started, the focus was the debt ceiling. Now the issue is that the ratings agencies have said they need to have a credible deficit-reduction program in place for them to take away the threat of a downgrade," Steven Englander, head of G10 FX Strategy at Citigroup told Reuters.

Many pension and money market funds could be forced to sell bond holding because of requirements that they hold AAA-rated investments. Few fund managers have taken any action to prepare for a default scenario.

"I don't think investors are prepared. It's hard to prepare for such a tail risk," Alessandro Bee, fixed income strategist at Sarasin, told Reuters. "It's like preparing for nuclear fallout."

In addition to roiling the bond markets, a downgrade would drive up interest rates, which would slam the struggling housing market and hurt businesses and consumers by raising the cost of borrowing.

"Playing Russian roulette with the bond market is a zero sum game," Christian Cooper, head of U.S. dollar rates derivatives at Jefferies & Co., told Reuters. "It is history's rule rather than the exception that the outcome of a default will be dramatically higher interest rates for all Americans and a generation-defining shift that will make job creation significantly more difficult."

In the world currency markets, a default will cause a slide in the U.S. dollar, driving up the cost of many imported products and commodities.

Beyond the credit issues, failure to raise the debt ceiling by Aug. 2 would force the government to immediately cut federal spending by about 40%, which could hurt companies reliant on government contracts.

"You have a number of sectors that can be getting hit from the credit downgrade and hit from the austerity," Dan Clifton, Head of Policy Research at Strategas, told Yahoo! Finance's Breakout. "There's a discretionary spending cap that would go into place."

Go for Gold

Given that a U.S. default would severely harm equities, bonds and the dollar, what should you do?

If the worst happens, one haven will be precious metals like gold and silver. In fact, gold hit a record high of $1,624.30 an ounce yesterday before falling back slightly. Silver was up 0.6% to $40.361 an ounce on the Comex.

"Gold is feeding off the uncertainty of the debt negotiations,"Matthew Zeman, a strategist at Kingsview Financial in Chicago, told Bloomberg News. "Gold is in a ‘can't lose' situation with the debt negotiations because regardless of the outcome, the dollar is going to suffer."

Oddly enough, short-dated Treasurys may also rally, simply because few liquid investments can match the size of the U.S. market – a lot of money will have nowhere else to go.

Of course, a major breakthrough deal before the debt ceiling crisis deadline would reverse all of this, sparking a big rally on Wall Street. That means you'll need to keep a close eye on Washington until all this is resolved.

"We believe Winston Churchill characterized the U.S. well when he said, 'You can always count on Americans to do the right thing after they've tried everything else,'" David Kotok, chairman and chief investment officer at Cumberland Advisors told Reuters. If not, "the markets will experience a horrible shock. The unthinkable will have occurred."

News and Related Story Links:

• Money Morning:
  The 2012 Election and the Truth Behind the Debt Ceiling Debate
• Money Morning:
  The Debt Ceiling Debate: Will the Democrats' Gambit Lead to a Victory in the 2012 Election?
• Money Morning:
  The Painful Consequences of a Debt Ceiling Increase
• Money Morning:
  Moody's Warning Edges U.S. Credit Rating Closer to Downgrade
• Wall Street Journal:
  White House Warns of Stress in Global Markets
• Bloomberg News:
  Stocks, Treasuries Drop on Rival Debt Plans
• USA Today:
  Money managers wary as the debt-ceiling debate drags on