Failure to raise the U.S.’s $14.3 trillion debt ceiling by Aug. 2 “could plunge the world economy back in recession,” President Barack Obama said. Treasury Secretary Timothy Geithner called it “unthinkably damaging,” and Federal Reserve Chairman Ben Bernanke said congressional inaction could result in “a huge financial calamity.”
This week, as negotiations between the president and leaders of Congress hit an impasse, Moody’s Investors Service placed the U.S.’s Aaa rating, in place since 1917, on review for a possible downgrade. Yet the one entity that stands to feel the direct impact of any such action by Moody’s, or inaction by Congress on the debt ceiling, is taking the whole thing in stride. That entity is the bond market.
With 18 days left before Aug. 2, the yield on the 10-year Treasury note is comfortably below 3. The 10-year rallied 45 basis points in the days after the July 7 release of the employment report for June, which offered no good news on the labor market.
Policy makers keep warning that failure to act would mean an immediate surge in borrowing costs, leading to higher interest payments on the federal debt and a bigger fiscal hole for government. So why is the bond market trading like a passive observer?
One popular explanation I’ll call the “least bad alternative.” As inept as Washington may be, the U.S. “still looks pretty good compared to the risks associated with European debt,” says Ward McCarthy, chief financial economist at Jeffries & Co.
Traders, subscribing to a version of the least-bad theory, said they think stocks would get hammered on any debt-limit breach, sparking a flight-to-quality into Treasuries. What’s more, the disruption in government transfer payments could have a temporary restraining effect on the economy, increasing demand for government bonds.
Another possibility is that investors know the U.S. Treasury can prioritize payments. There is adequate revenue coming in to make interest payments on the debt, thereby averting a technical default, and to cover Social Security, Medicare and Medicaid benefits.
An alternative explanation is that the bond market has seen this movie before and can write the script. It goes something like this:
1. Democrats and Republicans play chicken with the debt limit, fanning worst-possible fears to gain maximum concessions from the other party.
2. The president scares seniors by telling CBS News he can’t guarantee that Social Security checks will go out as planned on Aug. 3 without congressional action on the debt ceiling.
3. Congressional phone lines light up with seniors asking how Representative What’s-His-Name can be so irresponsible as to deprive old folks of their monthly checks, putting them in a position of choosing between eating dog food or starving.
4. The president and Congress, invoking the “235-year history of this great nation,” announce they have come together to save the American people from an unimagined fate. The debt ceiling is raised, what started as a grand bargain on deficit reduction and tax reform is a measly bunch of spending cuts and loophole fixes on paper that don’t amount to much in reality. The big decisions on the U.S.’s unsustainable fiscal imbalance are kicked down the road.
5. Treasuries sell off, and everyone wonders why.
The denouement may take awhile to unfold. In the short run, the ebb and flow of the economic data -- mostly ebbing right now -- are the major determinant of the direction and level of Treasury yields. That’s why bond yields fall during recession, even as the deficit balloons.
Deficits don’t matter -- until they do. Interest rates seldom provide an advance warning of a debt crisis, according to a July 13 Bloomberg View op-ed article by economists Carmen Reinhart and Kenneth Rogoff, authors of “This Time Is Different: Eight Centuries of Financial Folly.”
The bond market, in its infinite wisdom, may realize the issue is the federal debt itself, not the debt limit. Not much point wasting a lot of time and energy on the dress rehearsal.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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