How to tell if financial markets start to freak out about U.S. debt limit

July 1, 2011

The stand-off between congressional Republicans and the Obama administration over raising a legal limit on how much the nation can borrow has been filled with dire warnings about what will happen if the U.S. government fails to pay its debts.

In truth, it could be bad for the economy if global investors even begin to doubt the ability or willingness of U.S. officials to reach agreement on the debt ceiling. The U.S. government can borrow money more cheaply than almost any other entity on Earth, and that could change abruptly if investors conclude that the government is too dysfunctional to pay its bills on time. That would make it far more expensive for the federal government to service its existing debts, and increase interest rates across the economy.

“Given that we’re not on strong economic footing to begin with, higher interest rates and dislocations in the financial markets would probably have very bad ripple effects,” said Raymond Stone, co-founder of Stone & McCarthy Research Associates, a group that studies the economy and bond markets. “You’re treading on dangerous territory when you play with the credit worthiness of the federal government.”

So what are the early warning signs? If the bond market starts to panic over the U.S. government’s creditworthiness, how would we know?

Here are the indicators that bond market mavens, economists and government officials are watching for evidence that the markets are losing faith in the U.S. political system. The good news is that so far none of them are flashing red (though one is flashing yellow). The bad news is that when markets turn, it is often abruptly.

Discontinuities in the Treasury bill market. Short-term government debt comes due every week. The Treasury Department estimates the government will run out of money unless the $14.3 trillion debt limit is raised Aug. 2. One sign that financial markets are getting antsy would be if the prices of bonds maturing around that deadline start falling, meaning that investors would demand higher interest rates for holding them. Right now that’s not the case: The yield on bills maturing Aug. 4 is 0.01 percent, as low as can be — and identical to the yield on bills maturing Aug. 18 or Aug. 25, and less than the 0.02 percent on bills maturing in September. Get nervous if that changes.

A narrower spread between rates on Treasury bills and other forms of short-term credit. The U.S. government can borrow money for short time horizons for practically nothing — 0.01 to 0.03 percent — while the rates at which banks lend to one another are a bit higher: 0.18 percent for one month as measured by the London Interbank Borrowing Rate, for example, or 0.07 percent on overnight lending between U.S. banks at the federal funds rate. If the gap between the Treasury bills rate and those other rates compresses, or if the Treasury rate were to go higher than bank lending rates, it would be a sign that faith in the U.S. government is waning.

Spikes in the credit default swaps market. You can buy insurance against the U.S. government or almost any other borrower defaulting on its obligations, through credit default swaps. The price of those swaps rises as a default appears more likely, making the insurance more expensive. Greek credit default swaps, for example, are trading at prices that imply an 85 percent probability the country will default within five years. U.S. swaps imply only a 4.6 percent chance of a default within five years. This is the indicator that is flashing warning signs — it is up substantially since early April.

Higher volatility. If rates on government bonds suddenly start jumping around more dramatically than usual, or if contracts based on the future prices of Treasuries become more expensive because investors expect them to be more volatile in the future, it would imply that investors no longer view U.S. government debt as a safe, steady place to park money.

A narrower spread between Treasuries and near substitutes. If U.S. government bonds are suddenly viewed as more risky, investors may look to other safe places to park money. For example, 10-year U.S. Treasury bonds currently yield about the same (3.21 percent) as 10-year Canadian bonds (3.11 percent); if investors lose confidence in the United States, Treasury rates would rise while Canadian rates may fall as investors park money there instead, and a similar pattern would likely hold with other stable, credit-worthy governments such as Switzerland and Germany. Similarly, the gap between U.S. Treasury rates and high-credit-quality U.S. corporate bonds might narrow. After all, GE presumably doesn’t have a faction on its board of directors threatening to disallow the meeting of debt obligations.

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