Amid default bluster in Washington, bond markets remain cool

July 15, 2011

In Washington, the debate over the debt ceiling is the stuff of heated arguments, high-stakes brinksmanship and warnings that the global economy is teetering on edge.

Wall Street isn’t buying it. So far, at least, the bond investors who lend trillions of dollars to the U.S. government are keeping cool, confident that the ups and downs of debt talks are mere theatrics.

It’s not that investors aren’t jittery; presidential news conferences and statements by Republican congressional leaders are being closely watched on trading floors in the world’s financial capitals. And if the major credit rating firms were to downgrade their AAA ratings on U.S. debt, as they have threatened to do, there could be nasty and hard-to-
predict ripple effects through the financial system.

But investors are so far concluding that for all the drama, a deal will be struck to prevent the U.S. government from failing to meet its financial obligations after Aug. 2.

“If past history is a guide, they’ll take these negotiations until the last minute, and you can’t look at the day-to-day chatter as an indication of where things are really heading,” said Thomas Simons, money-market economist at Jeffries & Co. “They will raise the debt ceiling on time.”

Indeed, if the talks break down and there is no agreement by early August, it could have the paradoxical effect of making Treasury bonds more attractive. Investors expect the government to continue making payments due on its debt. But it could have to slash all manner of other spending, such as Social Security and payments to government contractors, which would weaken the economy. Traditionally, investors pile money into government bonds when the economy is weak.

“Everything that President Obama and [Treasury Secretary] Tim Geithner have said indicates that interest payments and maturing debt will be paid,” said Robert H. Dugger, managing partner of Hanover Investment Group. “The Treasury market is going to be fine. The problem is going to be tens of thousands of companies counting on millions of payments that are going to be delayed or canceled, and the negative impact on the employment prospects of millions of Americans.”

Dugger expects to see the impact of delays raising the debt ceiling to come in the form of lower stock prices and higher borrowing rates for corporations, rather than a sell-off of Treasury bonds.

That matches what has happened in financial markets in the past several days. The interest rate the government must pay to borrow money for two years was only 0.36 percent Friday, down a bit from a week earlier despite gridlock in the debt-ceiling negotiations.

Treasury bills set to be repaid in the first few weeks of August are trading at near-zero interest rates, implying that investors see virtually no risk of disruption to payments. The latest fluctuations in the bond market in recent days have been driven by economic news — such as Thursday’s better-than-expected news on retail sales and jobless claims — not the latest drama in Washington.

Another measure of the creditworthiness of the U.S. government, the price investors must pay to insure against a default, has risen in the past two weeks, but the level still reflects a belief the odds are very low that the government won’t meet its obligations.

There remains a risk that, absent a deal in the next two weeks, Standard & Poor’s and Moody’s Investors Service will cut the sterling U.S. credit rating. Many of the investors who own Treasury bonds do so in part because they are under legal or other requirements to invest only in AAA-rated debt. No one knows just what would happen if there was a downgrade, and there could be forced selling of Treasuries.

More fundamentally, if investors start to view the U.S. political system as dysfunctional, the long-standing view of the United States as a financial safe haven could change.

One major reason that hasn’t happened already is that there is a global shortage of super-safe places to park money, and the United States looks decent in relative terms. Europe is in the midst of a debt crisis of its own. Japan’s government has debts twice as large, relative to the size of its economy, as the United States. China severely restricts financial transactions.

The list of countries that have solid finances, sound governance and free capital markets is a short one: Australia, Canada and Switzerland come to mind. There are more global savings looking for a safe place to be invested than those countries could handle.

“There’s a tremendous amount of liquidity in the world, and it needs to get parked somewhere,” said Alan Levenson, chief economist of the mutual fund group T. Rowe Price.

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