Bond market optimism should scare us

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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 isnt the slightest bit worried: the people who buy bonds. If they were worried America wont repay the principal and interest, theyd 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 cant agree, and Treasury hits the ceiling? Heres 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 whack by even a technical default. It would also undermine the federal guarantee that backstops borrowing throughout the economy, from federal deposit insurance to the bonds backed by Fannie Mae, Freddie Mac, and the Federal Housing Administration.

These implications are so awful that the bond market assumes, almost certainly correctly, that Mr Geithner would not allow them to happen. It is far more likely that Treasury would delay other payments first, as Bill Clinton threatened to do, with Social Security cheques, in 1996.

What would that imply? At present, federal spending equals about 24% of GDP and revenue around 15%. The difference, 9%, is the deficit. Barring the federal government from ever raising the debt ceiling would in essence force it to balance its budget immediately, as states, which are constitutionally barred from running deficits, must do. And heres the thing: there are some in the Republican party, like Michele Bachmann. who would welcome that. This means it cant be ruled out.

To balance the budget would mean cutting spending by more than a third, immediately, that is by the economic equivalent of 9% of GDP. What would be the consequences (assuming it lasted more than a few days)? By way of comparison, GDP fell by 4.1% over the course of the 2007-2009 recession, the worst of the post-war period. If prolonged, the result would almost certainly be a severe recession and a further fall in inflation. This would be great for bonds, but it would be a calamity for the economy and workers. Thats why the fact that bonds arent worried should worry the rest of us.

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