Three signs that investors are getting nervous about a possible U.S. default

Put on your financial wonk hat. This week, there were three events in the world of exceedingly complicated financial markets that showed growing concern about the state of the debt negotiations in Washington:

● The dollar fell sharply against other currencies.

Gallery

Video

Senate Majority Leader Harry Reid (D-Nev.) said that Boehner's bill would not get any Democratic votes in the Senate at a news conference with Senate Democrats on Wednesday. (July 27)

Senate Majority Leader Harry Reid (D-Nev.) said that Boehner's bill would not get any Democratic votes in the Senate at a news conference with Senate Democrats on Wednesday. (July 27)

More on this Story

View all Items in this Story

No debt deal?

Here’s what could happen

● Investors who make short-term loans to the government demanded a higher interest rate.

● Investors who wanted to buy insurance against a U.S. default on its debt had to pay vastly more.

The three data points indicate that investors are getting antsy about whether leaders in Washington will actually forge a deal in the coming days.

Still, the markets are not in freak-out mode. U.S. stock markets ended the day just a smidgen down, well within what could happen on any day. And longer-term Treasury bonds, which paint a picture of the economy a year or more from now, showed no sign of trepidation.

For the markets, there are two separate, though linked, issues.

First, the government says it needs to raise the federal limit on borrowing by Aug. 2. That’s the last day the Treasury Department can turn to the markets to borrow money without Congress raising the $14.3 trillion debt limit.

If Congress fails to do so, Treasury would soon run out of money to pay all of its obligations. How soon is a matter of debate — anywhere from a day to a few weeks. The Treasury receives tax revenues every day to help pay the bills and has about $90 billion in a savings account.

But eventually, the government wouldn’t be able to pay all of the bills. Tax revenue would only cover about 60 percent of expenses.

Paying back investors in Treasury bonds is sacrosanct, so virtually everyone agrees they’ll get their money back. President Obama would have to make a “Sophie’s choice” about what else to pay — Social Security checks or unemployment benefits or military salaries or many other obligations.

The second issue is more worrisome for the market — whether one of the credit-rating firms would follow through on their threats to downgrade the United States.

That could happen if the government either fails to increase the debt ceiling or fails to come up with a solid plan to tame the debt over the long term.

In a conference call Tuesday, Terry Belton, global head of fixed- income strategy at J.P. Morgan Chase, said the impact of a downgrade might be quite mild at first.

But over the longer term, he said, it would probably increase the interest rate that the government must pay by a “huge number” — as much as 0.7 percentage points. Or, in other words, it could cost $100 billion more in interest per year.

“We’re talking about a long-term permanent increase in U.S. borrowing costs,” Belton said.

In the short term, he said, a downgrade isn’t likely to cause much disruption.

“The primary reason is that, in general, asset managers are not going to be required to sell Treasurys” as a result of a downgrade, he said. “Most investors indicate they’d continue to hold them.”

That’s good news for Treasury officials, who worry that a failure to raise the debt ceiling could spark a market panic.

Mike Hanson, senior U.S. economist at Bank of America Merrill Lynch, said a significant increase in borrowing costs would make it even more difficult for the government to tame the debt.

The interest rate on Treasury bonds is the baseline rate for many other kinds of debt: business loans, credit cards, mortgages. Higher interest rates mean less borrowing, which means less spending, which means slower economic growth.

When the economy slows down, people pay less in taxes. That requires the government to borrow more. And since interest rates would be higher, the government would have to pay more to do so.

“If we’re at a situation where the U.S. has lost some of its long-term credibility . . . that does make it harder to have a long-term sustainable budget situation,” Hanson said.

 
Read what others are saying