How to Protect Yourself From a U.S. Debt Default

The U.S. is in a very scary position right now… We have a real chance of defaulting on our debt. The government is still arguing over what to do about the debt ceiling, and if they can’t find a solution we’re looking at an economic meltdown.

The rating agencies are starting to catch on.

Moody’s warned yesterday that it could downgrade the U.S.’s credit rating if Congress and the president couldn’t reach an agreement. It would probably change the country’s AAA rating to AA. Standard and Poor’s would make a bigger change — downgrading the U.S. from AAA to D.

This has all kinds of global ramifications. We could see another credit crunch like back in 2008.

Yesterday, Fed Chairman Ben Bernanke spoke to Congress. He warned:

If we went so far as to default on the debt, it would be a major crisis because the Treasury security is viewed as the safest and most liquid security in the world. It’s the foundation for most of our financial — for much of our financial system. And the notion that it would become suddenly unreliable and illiquid would throw shock waves through the entire global financial system.

It will truly be another global financial crisis…

The question is, what does this mean for you? What will a default mean for your investments and your personal wealth?

On one hand, a debt default would push interest rates on Treasury bonds higher. Higher rates eat up more taxpayer money, leaving less money for the government to run on. In other words, funding could be cut for social and healthcare programs, for schools, and even for infrastructure projects like roads and bridges.

But a debt default has other consequences that cut closer to the bone.

Here are a few outcomes… and how to protect yourself against them.

Debt Default Would Raise Borrowing Costs

Nearly all interest rates use U.S. Treasuries as a benchmark. If Treasury rates climb, then the interest rates for things like mortgages, personal loans and credit cards would climb.

Corporations will see a sharp increase in borrowing costs, having a big effect on share prices and jobs.

On a personal level, if you’ve been considering refinancing or buying a new car, you should aim to get that done before Aug. 2. That’s the deadline the government has before it defaults on its debt. If an agreement can’t be reached to raise the debt ceiling, than interest rates will jump higher.

In the markets, be sure to check on the health of the companies you hold. High levels of debt that might need to be refinanced could be a sign of potential weakness come Aug. 2.

Companies have been borrowing at an extremely high rate… They borrowed some $513 billion in the first quarter of 2011 alone. In total? Non-financial corporations have borrowed $7.3 trillion. Their debt has climbed 24% in the past five years.

Use the company’s debt-equity ratio to help determine health. We’ve told you here at Smart Investing Daily that good “value” stocks tend to have a debt-equity ratio of less than one. That will probably be hard to find in this environment, but it’s a good gauge nonetheless.

(Don’t forget to sign up for Smart Investing Daily and let me and fellow editor Jared Levy simplify the market for you with our easy-to-understand articles.)

Debt Default Means Millions of Americans Won’t Get Paid

According to the Bipartisan Policy Center, the U.S. has monthly deficits of $125 billion. If the debt ceiling isn’t raised, the government can’t pay its bills. Some people may be left without a check. We don’t know who it will be…

It could be Social Security recipients, or soldiers, or federal workers.

Indeed, President Obama said in a CBS interview that he couldn’t guarantee that government benefits, including Social Security, could be paid.

There will be some really tough decisions to be made on Aug. 2.

If you receive any kind of check from the government, be prepared not to get it. That means you might need to liquidate some other assets if you know you’re going to need cash. But do it soon… If the government defaults, the stock market is going to take a beating.

Debt Default Means Inflation

The Federal Reserve has stepped in twice to buy up government debt and keep the recovery going. Think it’ll sit on the sidelines if the government defaults? Not a chance…

In this case, the third time’s not the charm — it’s the beginning of massive inflation.

Even if the debt ceiling is not raised, and the government can’t issue more U.S. Treasury bonds for the Fed to buy, the Fed has two other tricks in its pockets.

The Federal Reserve can keep borrowing rates “exceptionally low,” as it’s promised to do for an “extended period.” And it can start paying banks less interest on the cash they keep at the Fed. This could make some banks take that money out and put it into the market.

Either way, this flood of dollars — through cheap borrowing rates and banks injecting cash into the market — will mean inflation.

We’ve already seen gold hit record highs on the news that Moody’s could downgrade U.S. debt. Gold is the top choice for investors who want to protect their wealth from inflation. We’ve recommended that every investor should permanently keep a portion of his portfolio filled with gold.

Pullbacks in the price of gold should be considered buying opportunities. You can also look at other precious metals, like silver and platinum, as hedges. Even other commodities — oil and agricultural grains — have the power to protect your portfolio from inflation.

Beware of oil, though. A big dent in our economic growth could hit oil demand, so keep that in mind when using oil as an inflation hedge.

The next two weeks are going to get pretty crazy. It’s possible that we’ll see the Dow test 12,000 again, and the S&P 500 could fall to 1,250. But be just as ready for rebounds…

The markets will whipsaw with the news, as it did yesterday. News that Bernanke could step in and boost the economy again pushed the market way higher. But news that Moody’s could downgrade the U.S.’s credit rating erased those gains.

The ups and downs will only get sharper for the rest of the month…

Publisher’s Note: If Washington can’t reach a deal, the facts are clear. Volatility will soar — fantastic news for options investors. In fact, some traders say the impasse in Washington could be the greatest wealth-building opportunity of a generation.

Zach Scheidt just finished his latest research report. He unveils where the biggest problems lurk… and the biggest opportunities. To read his work, follow the link.

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