Fading hopes the Congress will strike a deal in debt talks any time soon have left investors scrambling to position themselves for what many now view as an inevitable downgrade of the U.S.
The two latest plans proposed by the Democrats and Republicans to deal with the deficit in the medium term are not enough to stop Standard & Poor's from stripping the U.S. of its AAA rating.
"We see a growing chance that, even if Congress raises the debt ceiling, Moody's or S&P may still cut the U.S. credit rating, based on the risk introduced by the current situation as well as the longer-term budget imbalance," said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott.
Many investors have been complacent in assuming the U.S. will retain its pristine rating and are now reviewing their hedging options to protect themselves from the heavy losses that would likely be triggered by a downgrade.
That includes a cushion against higher interest rates for a broad range of government securities as investors are expected to demand higher payments to compensate for extra risk.
Treasuries are still the most liquid securities on the planet and are expected to retain their safe-haven status. But demand is likely to focus on the short-end of the curve, most likely in the form of T-bills, as investors limit their longer-term exposure.
T-bills may even turn negative while longer-dated maturity yields are likely to spike.
Investors are selling longer duration assets, while flows into the ProShares UltraShort Treasury ETF (TBT), which places a leveraged bet against falling Treasury prices with maturities of more than 20 years, have pushed assets under management to a record level this week. Daily trading volume is up about 30 percent in the past week than the average of the last 3 months.
TREASURIES TO RE-PRICE
Credit experts are recommending that investors take a wait-and-see approach.
"The problem is that the U.S. is so dominant there are not a lot of places to go," said Ashish Shah, global head of credit at Alliance Bernstein. "In the event of a downgrade, the only thing left to do is to re-price."
While a downgrade is a reasonable probability, but not a certainty, investors should scale back risk positions, he said.
"Within our portfolios we have generally felt that this is an environment to be more conservative in our risk metrics. Our long term perspective is that in the middle of a cycle it is attractive to be long in risk, but with risk parameters being what they are, we have reduced this position accordingly."
A downgrade will impact the entire economy if consumers and businesses face higher borrowing costs because of higher Treasuries yields. That could have a dramatic effect on a companies' ability to tap the primary market, particularly for lower-rated securities.
Corporate profits are expected to suffer as profit margins would compress, sending spreads across the credit spectrum wider.
"We believe a downgrade will negatively impact risk assets in the near-term," said Ed Fitzpatrick, a fixed income fund manager at Schroders in New York. "But the question mark is the extent of the shock: with a fragile economy and relatively weak consumer and business confidence, a downgrade could have costly economic ramifications."
Kathy Jones, a fixed income strategist at Charles Schwab is advising investors to keep duration short to relatively intermediate.
"It is not a 100 percent certainty that rates will rise significantly or for a long period of time, but our advice is to play it safe," she said.
Jones also recommends limiting or at least reassessing exposure to the financial sector, particularly to systemically important banks.
Others warn a downgrade could have an unintended consequence.
"Funds that are required to maintain an average rating of middle double A credit quality may be forced to sell lower rated credits to bring the average rating of the portfolio up," said Steve Johnson, U.S. CIO of Deutsche Bank Private Wealth Management during an open discussion on Tuesday.
VIX COUNTERS TREND
Even if the debt limit is increased, a deficit reduction plan agreed and a downgrade averted, the fiscal situation in many countries is deteriorating. That will make it more difficult to solve the longer-term debt problem.
To meet their enormous financial obligations, the U.S. and Europe could to debase their currencies by letting inflation rip or worse by printing money.
That possibility has boosted gold. The yellow metal has been one of the main beneficiaries of the Fed's attempt to reflate the U.S. economy with quantitative easing, holding its value thorough all of the turmoil.
While gold will likely spike higher than its current price of $1,600 an ounce in the event of a downgrade, other commodities will be sold if the dollar weakens and global growth expectations are scaled back.
Investors are building exposure to foreign currencies that would benefit from a collapse in the dollar, such as the Swiss franc. The Swissie is at an all-time high versus the dollar at $1.2408, up more than 14 percent since the start of the year.
Switzerland is considered fiscally stable because it has a large current-account surplus and does not rely on outside creditors to fund its public finances.
Forex reserve managers are continuing to look to diversify away from the dollar as headline risk worsens. Record inflows into ETF's that bet against the US dollar, such as the Powershares DB USD Index Bearish ETF (UDN), are sending them to new highs as the dollar has depreciated against a basket of global currencies.
One indicator that is not pricing in an immediate downgrade of US debt is the CBOE Market Volatility Index (VIX), known as the fear index. The index uses out-of-the-money puts and calls to determine how volatile the S&P 500 is expected to be in the next 30 days.
The VIX is currently trading at a relatively moderate risk level of 18.75, well below levels above 70 seen at the height of the 2008 credit crisis.
Some investors view that as historically cheap and are not showing much alarm as we approach the August 2 deadline. Instead, they have been turning in huge volumes toward the iPath S&P 500 VIX Futures ETN (VXX).