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Archive for Tuesday, July 26, 2011

Investors try to prepare for default as talks continue

July 26, 2011

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— Scrambling to protect themselves against a U.S. default, investors are buying gold and foreign currencies, using derivatives to bet on a stock market collapse and taking out complicated insurance policies.

They may want to consider crossing their fingers.

If the United States suddenly stiffed its creditors, the impact would be so widespread, complex and unpredictable that it is next to impossible to shield against steep losses, experts say.

A default could cause turmoil in the stock and bond markets, plus a replay of the fear that froze lending in the depths of the 2008 financial crisis. In the chaos, investments you’d think were a sure bet to fall might rise instead, and vice versa.

Consider the assets at the heart of the crisis — Treasury bonds. You would expect interest rates on Treasurys to rise the closer Washington gets to missing a debt payment. Investors would demand higher rates because of the greater risk they wouldn’t get their money back. After Argentina defaulted in 2002, foreign lenders required higher rates.

But some bond traders are betting the opposite will happen. They think nervous money managers could rush into Treasurys if Washington blows past the Aug. 2 deadline to raise the debt ceiling. The buying would push interest rates lower.

The logic behind this seemingly illogical reaction: Treasurys are widely traded around the world, with plenty of buyers and sellers ready at a moment’s notice, a quality known as liquidity. Investors like that, especially in a crisis, and may overlook fears of missed payments.

Gifford Combs, a portfolio manager at Dalton Investments, which manages $1.3B in assets, has been buying short-term Treasury bills for this reason. But he concedes he’s not sure what could happen in the event of a default.

“If there is a financial meltdown and panic, you don’t know where investors will go,” he says.

A second reason to like Treasurys: A default could help sink the economic recovery. Dan Greenhaus, chief global strategist at brokerage BTIG, thinks Washington is likely to continue paying interest on its bonds, keeping creditors happy even if it means gutting other government spending. The massive drop in government spending would then drag down the economy. And when economic growth looks grim, traders turn to Treasurys.

“No matter what happens, Treasurys are still the safe haven,” Greenhaus says. “No other market is as large or as liquid.”

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