The great folk rocker Neil Young has a famous song titled, “The Needle and the Damage Done,” and that title phrase came to my mind when contemplating the debt-ceiling debacle, and the current failure of the powers that be in Washington to pound out a deal that keeps the U.S. from essentially going into default.

President Obama has suggested that Social Security recipients may not receive benefit checks if the debt ceiling isn’t raised by Aug. 2. Some have argued this is fear mongering, and I tend to agree; however, the fact is that if there isn’t a deal done to lift the debt ceiling, there won’t be enough money to keep the federal leviathan going.

From a trader’s point of view, a failure to reach a deal that enables the government to keep borrowing—and to keep from defaulting on bondholders—is one huge unknown. Some say that financial markets would go haywire, while others say that the damage would be minimal.

Former Treasury Secretary Lawrence Summers said failure by Congress and the President to raise the debt ceiling would lead to “the Lehman event on steroids,” a reference to the bankruptcy of Lehman Brothers in September 2008, which was a key event that helped ignite the worst financial crisis to afflict the U.S. since the Great Depression.

In an interview on “The Charlie Rose Show,” Summers added, “The buck will be broken in money market funds; Americans will rush to get cash and put it under their mattresses; major corporations will be unable to borrow; the stock market will crash and, quite likely, the base mechanisms of payments that keep the economy going will break down.”

That’s a scary scenario, and if Summers is even close to being right on any of those fronts, investors will want to be prepared. But how do you prepare your portfolio for the potential fallout from a defaulting on U.S. government debt?

First off, your money needs to be fluid, meaning you have to make sure you can move rapidly from sector to sector. That means the use of hyper-mobile, exchange-traded funds (ETFs). ETFs allow you to move in and out of the market quickly, and at a very low cost compared to mutual funds. Plus, ETFs can be traded anytime of the day, unlike mutual funds. Of course, the question still remains which ETFs can provide shelter from a collapsing debt ceiling?

If the U.S. goes into default, then our credit rating would come into immediate jeopardy. On July 13, Moody’s Investors Service threatened to lower the United States’ AAA bond rating if a deal on the debt ceiling isn’t reached. A downgrade of the nation’s debt would immediately cause interest rates on U.S. Treasury bonds to surge, and that’s an event playable via the ProShares Short 20+ Treasury Bond (TBF).

This ETF moves in the opposite direction of long-term Treasury bond prices, or put another way, it moves in concert with rising bond yields. If bond yields spike in order to make them more attractive to potential bond buyers, then TBF also will rise.

Another likely scenario for the markets if a government default occurs is a major selloff in global equity markets. If the selling gets ugly, then an ETF such as the ProShares Short S&P 500 (SH) is a fund you’ll want to own. This inverse ETF moves in the opposite direction of the S&P 500 Index, so if the S&P falls 3%, then SH should rise 3%. Being short the domestic market when a debt-ceiling inspired selloff begins is a sure way to bank some protective profits.

Finally, value of the U.S. dollar would undoubtedly come under severe pressure if the Aug. 2 debt-ceiling deadline comes and goes without a deal in place. Confidence in the ability of the U.S. government to fulfill its most basic responsibilities would come under severe duress, and that could send the dollar plunging.

When the dollar is in decline, it makes more tangible assets such as gold more valuable, and that means traders can take shelter in the SPDR Gold Trust (GLD), a fund that holds physical gold, and that’s pegged to the spot price of the yellow metal. In fact, we’ve just witnessed gold surge to all-time highs, but that high-water mark in gold could easily be exceeded if traders move en masse out of dollar-denominated assets and into hard assets such as gold.

We’re 5 for 5 on Gold Trades in the Last Two Weeks

Gold and its cousins, silver and the gold miners, are moving and moving fast. The coming week and the growing crises on both sides of the Atlantic make it a hot commodity. Find out how you can get in our new gold trades this week.

Certainly, few traders want to see the debt-ceiling issue left unresolved. However, part of your duty as a trader is to be ready to mitigate the damage that could be done if the worst-case scenario does, in fact, play out. With these three ETFs, you’ll be ready to rock and roll through even the most dissonant debt-ceiling inspired beat.

 

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