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Bond market holds its nerve under fire

Failure to raise the United States' $US14.3 trillion ($13.4 trillion) debt ceiling by August 2 "could plunge the world economy back in recession", President Barack Obama said. The Treasury Secretary, Timothy Geithner, called it "unthinkably damaging" and the Federal Reserve chairman, Ben Bernanke, said congressional inaction could result in "a huge financial calamity".

Failure to raise the United States' $US14.3 trillion ($13.4 trillion) debt ceiling by August 2 "could plunge the world economy back in recession", President Barack Obama said. The Treasury Secretary, Timothy Geithner, called it "unthinkably damaging" and the Federal Reserve chairman, Ben Bernanke, said congressional inaction could result in "a huge financial calamity".

Everyone from Warren Buffett to Bill Gross to Robert Rubin is weighing in, calling it totally irresponsible.

Last week, as negotiations between Obama and Congress leaders hit an impasse, Moody's put the US's AAA rating, in place since 1917, on review for a possible downgrade. Yet the one entity that stands to feel the direct impact of any such action by Moody's, or inaction by Congress on the debt ceiling, is taking the whole thing in its stride.

That entity is the bond market. With little more than a fortnight until August 2, the yield on the 10-year Treasury note is comfortably below 3. The 10-year rallied by 45 basis points in the days after the July 7 release of the employment report for June, which offered no good news on the labour market.

Policymakers keep warning that failure to act would mean an immediate surge in borrowing costs, leading to higher interest payments on the federal debt and a bigger fiscal hole for government. So why is the bond market trading like a passive observer?

One popular explanation I'll call the "least-bad alternative". As inept as Washington may be, the US "still looks pretty good compared to the risks associated with European debt", says Ward McCarthy, chief financial economist at Jeffries & Co.

Traders, subscribing to a version of the least-bad theory, say they think stocks will get hammered in any debt-limit breach, sparking a flight-to-quality into treasuries. What's more, the disruption in government transfer payments could have a temporary restraining effect on the economy, increasing demand for government bonds.

Another possibility is that investors know the US Treasury can prioritise payments. There is adequate revenue coming in to make interest payments on the debt, thereby averting a technical default, and to cover social security, Medicare and Medicaid benefits.

An alternative explanation is that the bond market has seen this movie before and can write the script. It goes something like this:

1. Democrats and Republicans play chicken with the debt limit, fanning worst-possible fears to gain maximum concessions from the other party.

2. The President scares older people by saying he cannot guarantee that social security checks will go out as planned on August 3 without congressional action on the debt ceiling.

3. Congressional phone lines light up with the elderly asking how Representative What's-His-Name can be so irresponsible as to put old folks in a position of choosing between eating dog food or starving.

4. The President and Congress, invoking the "235-year history of this great nation", announce they have come together to save the people from an unimagined fate. The debt ceiling is raised, and what started as a grand bargain on deficit reduction and tax reform is a measly bunch of spending cuts and loophole fixes on paper that don't amount to much in reality. The big decisions on the US's unsustainable fiscal imbalance are kicked down the road.

5. Treasury bonds sell off and everyone wonders why.

The denouement may take a while to unfold. In the short run, the ebb and flow of the economic data - mostly ebbing right now - are the major determinants of the direction and level of Treasury yields. That's why bond yields fall during recession, even as the deficit balloons.

The bond market, in its infinite wisdom, may realise the issue is the federal debt itself, not the debt limit. Not much point wasting a lot of time and energy on the dress rehearsal.


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