Washington Plays With Fire — Here’s the Worst-Case Scenario

Is it just me, or does it feel like we’ve been here before? Not once. Not twice. But repeatedly over the past few years.

I’m talking about being on the brink of a crisis, one sparked by budget and policy fights in Washington. Think the sequester battle at the end of 2012, the debt-ceiling debate in the summer of 2011, the 2009 battles over the Obama stimulus package — you name it.

And it’s not just Washington, either. Look at what happened in Europe between 2010 and 2012.

Throughout that two-year sovereign-debt crisis, as the price of the “PIIGS” bonds collapsed and the economy slumped, policymakers gathered for summit after summit. They cooked up “fix” after “fix,” only to watch the crisis continue to gather steam.

Things didn’t finally settle down until ECB President Mario Draghi issued his infamous “whatever it takes” comments more than a year ago. But even that didn’t fully fix things — just witness the economic implosion and banking-system collapse in European Union member Cyprus a few months later.

So what are my thoughts about the current D.C.-driven crisis? The obvious answer is that Washington is once again playing with fire. The economy has moved far beyond the credit crisis and Great Recession days of 2007-2009. But business and consumer confidence remains fragile, and economic growth is not as robust as it should be.

The longer the fight over a continuing resolution to fund the government lasts, and the longer Washington remains largely locked down, the more potential damage the economy faces.

The shutdown’s unexpected closures.

Then there’s the fact the country is bumping up against the debt ceiling in just a couple weeks. Considering the Dow Industrials plunged more than 2,000 points in just a few weeks in 2011 — when we last had a major debt-ceiling debacle — you can understand why markets are on edge.

I’ve been leery of the progression of events for a while now this year. First, we saw the bond market begin to collapse in early 2013. Second, we saw notable underperformance among financial shares in the summer. Then in the past few weeks, we saw even more narrowing in the stock market, and a sharp decline in the value of the U.S. dollar.

That’s why I took several rounds of profits off the table in my Safe Money Report this spring and summer, and why I’ve been carrying some hedges in the model portfolio.

[Editor’s Note: Want to see more of Mike’s strategies? Then click here.]

Now, given the market volatility and turmoil over the past few weeks, what is the worst-case scenario? The simultaneous selling of all U.S. assets.

We’re already seeing U.S. stocks slump, and we’re already seeing the dollar fall. That’s a clear sign that foreign investors in our markets are getting more and more worried about the shenanigans in Washington, and are yanking money out of our markets to protect themselves.

As for U.S. bonds, they’ve bounced a bit in price over the past couple of weeks. But the rally is incredibly anemic considering how much value they’ve lost over the past year. And considering the brinksmanship that’s once again apparent in Washington, a worst-case scenario could easily involve Treasury bonds plunging in price right alongside U.S. stocks.

That doesn’t mean it has to happen, of course. There could be a “25th hour deal” like the 24th-hour deals we’ve seen in the past. But if you haven’t bought some cheap protection against that possibility, or haven’t taken some gains off the table, despite my recommendations, maybe now is the time to think about doing so.

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Until next time,

Mike