Treasures and the Debt Limit
The Treasury market continues to shrug off debt limit concerns even as negotiations between Democrats and Republicans deteriorated. With an agreement on raising the debt limit seemingly farther apart and the August 2 deadline only two weeks away, the Treasury market failed to show any visible signs of worry. In fact, Treasury yields closed last week with the benchmark 10-year yield closing back below 3.0%. It seems contradictory that as the United States approaches a possible technical default, its government bond prices remain near recent highs.
The most obvious explanation for Treasury market resilience is simply that the vast majority of bond market participants do not believe that a default will occur. We agree. We believe an agreement will be reached and view a default as extremely unlikely.
However, we believe Treasury resilience also reflects what might occur if an agreement is not reached by the August 2 deadline. In the absence of a new debt ceiling, the Treasury will do everything in its power to maintain timely interest payments and repayment of principal on existing Treasury obligations. A look at the Treasury’s monthly budget reveals that interest expense comprises only a small portion of monthly Treasury revenue. The projected $210 billion in revenues the Treasury will receive in August is more than sufficient to cover approximately $30 billion in Treasury note and bond interest payments. Repayment of principal is trickier but can still be accomplished. Aside from prioritizing cash to Treasury debt service, the Treasury can still rollover maturing debt, even if a reduced amount, in order to remain under the existing debt ceiling, as long as investors maintain confidence that an agreement will ultimately be reached and are therefore willing to buy new bonds.
Treasury prices are likely to decline and yields rise in the absence of a new debt limit but riskier segments of financial markets may likely perform worse in our view. In order to prioritize debt service, the Treasury will have to reduce spending by 44%. A variety of outlays including social security checks, Medicare and Medicaid payments, unemployment benefits, and other government aid will be halted in order to prioritize payments for Treasury securities. Such action has two main consequences for the economy and financial markets:
- The sharp reduction in government spending would have very negative consequences for the economy and riskier asset classes will likely underperform Treasuries. More economically sensitive securities such as high-yield bonds and stocks, in particular, may decline further in price simply due to their economic sensitivity. Under this scenario Treasury prices may find some support as a safe haven particularly if the market believes a new debt limit will be agreed upon soon.
- Treasury market disruptions may ripple across the bond market. The Treasury market remains the backbone of the bond market. However, in the absence of a new debt limit, Treasury market issuance will be disrupted and could adversely impact overall bond market liquidity — the ease of buying and selling securities. More volatile Treasury trading may likely result in investors demanding higher risk premiums for less liquid bond sectors, such as corporate bonds and high-yield bonds. More economically sensitive bond prices may decline further than Treasury prices in that scenario.
