May 16, 2011

Bond market optimism should scare us

Great article, good analysis.

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Bond market optimism should scare us

TODAY, Treasury reached its debt ceiling and began emergency manoeuvres to gain a few months before running out of borrowing room. Most everyone agrees that failure to raise the debt ceiling before that happens would be a calamity. Tim Geithner, the Treasury secretary, has just warned for the umpteenth time that it would lead to "catastrophic far-reaching damage", sending interest rates skyrocketing and unleashing chaos on the American economy and the financial system.

Oddly, one particularly influential group of observers isn't the slightest bit worried: the people who buy bonds. If they were worried America won't repay the principal and interest, they'd demand higher interest rates as compensation. In fact, the opposite has happened. In a little over a month, as the White House and Republicans have dug in over the issue, the yield on the 10-year Treasury bond has fallen to just 3.15% today from 3.6% a little over a month ago.

What seems nonsensical makes perfect, and worrying, sense if you understand how this debate is likely to play out.

First, yields have come down partly because the economy has failed to pick up momentum this year as widely expected. A slower-growing economy means less inflation pressure and a Federal Reserve that will wait longer before raising short-term interest rates from around zero.

Second, under what circumstances will the debt ceiling be raised? To happen before the deadline, that would almost certainly require Barack Obama and Republicans to agree to significant cuts in the deficit over the next 10 years. That would imply Treasury borrowing less than it otherwise would, which would mean lower interest rates, other things equal. It also means a weaker economy and short-term rates stuck at zero even longer. These forces would be multiplied if Republicans prevail and deeper cuts begin immediately, with no tax increases.

Now, what if the two sides can't agree, and Treasury hits the ceiling? Here's where it gets interesting. Treasury has said that it would be forced to default, without specifying on what: besides interest on our bonds, it could be Social Security cheques, Medicare and Medicaid payments, salaries to soldiers and civil servants, student loans, and so on.

Some people, most recently Stan Druckenmiller, a legendary hedge fund manager, have said a "technical default"—that is, a few days' delay in the payment of our interest while politicians negotiate—is no big deal. Maybe so for a buy and hold investor. But Treasury debt underpins a vast and complex web of financial relationships around the world which would all be thrown out of w...

Thanks Billy Bayne

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