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US Default Could Send Investors Fleeing to—Treasurys

If Congress fails to reach a debt agreement by Aug. 2 and triggers a U.S. default, Treasurys could actually end up being the beneficiaries, traders and strategists said.

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The shock from the default by the world’s largest economy— and home of the globe’s reserve currency—could send investors fleeing to the safety of the very securities being downgraded, which would still be rated just one notch below triple-A.

Plus, a default may spur Congress to finally enact a strict— and bond-friendly—deficit reduction plan.

“The ironic thing—and it’s not out of the realm of possibility—is that the financial panic from these events could actually rally Treasuries on what would be the ‘Mother of all’ fear trades,” said Nicholas Colas, chief market strategist for ConvergEx Group.

“The response of U.S. Treasuries to the threat of a downgrade has been muted and we continue to expect the outlook for Treasuries to be dominated by the outlook for the economy,” said Marc Chandler, global head of currency strategy for BBH, in a note. “If a ratings downgrade spurred Congress to agree on a credible strategy for deficit reduction in the near future, it could even perhaps have a positive medium-term impact on Treasuries.”

This kind of reaction would not be unprecedented. The 10-year Japanese government bond has increased, driving its yield to an eight-month low, since the country’s debt was downgraded by Standard & Poor’s in January.

“Who cares?” said David Rosenberg, chief economist and strategist for Gluskin Sheff, in a note. Japan “is a double-A credit and yet still enjoys a 1.1 percent yield on its 10-Year JGB.”

Markets may already be signaling that Treasuries will be a buy post-default. The credit default spreads on U.S. sovereign debt (insurance to protect one from a default) have blown out since April, yet the yield in the 10-year has continued to plumb new lows and prices new highs.

“When fiscal deficits reach the point that they are no longer sustainable either economically (Greece and Ireland) or politically (US), investors begin to think about how big spending cuts and tax increases will impact the income statements and balance sheets of the companies in which they are invested,” wrote Rob Dugger, the former economist for Paul Tudor Jones’s Tudor Investment Corp., in a piece back in May.

“As investors sell U.S. company debt and stocks, some rotate out of US dollars altogether, weakening the dollar. But others are bound by asset allocation rules and must stay in USD assets. These investors will sell private assets and roll into the safe haven of Treasuries.”

To be sure, some traders believe a default of U.S. debt, given its stature on top of the collateral scale, would cause quite a volatile and violent reaction. Foreign investors may look at the failure by Congress to cut a deal this time as evidence that further agreements in the future may be just as hard to come by.

“I would just be long gold, silver and other hard assets,” said Jim Iuorio of TJM Institutional Services.

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Trader disclosure: On July 11, 2011, the following stocks and commodities mentioned or intended to be mentioned on CNBC’s "Fast Money" were owned by the "Fast Money" traders; Adami Owns (AGU); Adami Owns (C); Adami Owns (GS); Adami Owns (INTC); Adami Owns (MSFT); Adami Owns (NUE); Adami Owns (BTU); Terranova owns (XOM); Terranova owns (HAS); Terranova owns (DIS); Terranova owns (WFM); Terranova owns (LULU); Terranova owns (MSFT); Terranova owns (TM); Terranova owns (JWN); Terranova owns (MCD); Terranova owns (PEP); Terranova owns (MA); Terranova owns (BX); Terranova owns (GS); Terranova owns (DAR); Terranova owns (CAT); Terranova owns (VRTS); Terranova owns (AAPL); Terranova owns (F); Terranova owns (CVI); Terranova owns (IBM); Terranova owns (FCX); Terranova is Chief Market Strategist of Virtus Investment Partners, LTD; Finerman's Firm And Finerman Own (AAPL); Finerman's Firm owns (BAC) leaps and Finerman Owns (BAC); Finerman's Firm owns (JPM) leaps and Finerman Owns (JPM); Finerman’s Firm owns (GOOG); Finerman’s owns (IBM); Finerman's Firm Is Short (IWM); Finerman's Firm Is Short (MDY); Finerman's Firm Is Short (SPY); Finerman's Firm Is Long S&P 500 Puts; Finerman's Firm Is Long Russell 2000 Puts; Weiss owns (JPM); Weiss owns (HBAN); Weiss owns (CMA); Weiss owns (KEY); Weiss owns (COP); Weiss owns (DVN); Weiss owns (HK)

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Terranova is Chief Market Strategist of Virtus Investment Partners, LTD
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