The US debt crisis yields bigger headaches

Equity markets will bounce back from the US debacle, but 10-year Treasury yields are heading skyward. The effects will strangle consumers and hurt domestic growth.

The stand-off between US Democrats and Republicans is disrupting the Federal Reserve’s good work towards one of its key goals for domestic growth: a sustained, lower 10-year Treasury yield.

In what appears to be a bid to progress a resolution, ratings agency Fitch has weighed in on US political dramas, placing the federal government’s AAA rating on negative watch. No doubt Fitch’s assessment of the US political spectacle will spark a more concerted level of fear in markets as the debt ceiling limit has been seemingly ignored by equity markets

The yield on the 10-year US Treasury note has climbed to 2.73 per cent as the debt ceiling stalemate gathers more attention. Not so long ago, when there was only mere talk of tapering, the yield spiked to 2.99 per cent. It was evident the US economy couldn’t handle rates at such a high level, relatively speaking. Consequently, tapering didn’t happen, largely because the economic data concluded the economy wasn’t strong enough to support such action.

The US economy is largely driven by consumption. To be exact, it equates to around 70 per cent of GDP. Accepting that housing drives consumption, rising mortgage rates – spurred by higher 10-year Treasury yields – will strangle US consumers.

The debt ceiling drama has implications that reach further than the immediate impact on financial markets alone. It is likely the stand-off will be resolved and equity markets will recover, but the path taken to get to this point could have a more long-lasting and profound impact on the US economy and consequently the global economy.

Marc Faber, author of the Gloom Boom & Doom report, says it best: “The government has grown disproportionately large and that retards economic growth.” This is not directed at the US alone and is reflective of problems plaguing the world’s largest governments.

At this rate it is inevitable that investor panic with see markets slide and eventually trigger a political resolution. Relief will then drive a market rally, and President Obama can say he has saved America – and the world – from a financial apocalypse.

But there will be ongoing problems for the US if the 10-year Treasury yield remains elevated, while the government faces potentially an even bigger issue than raising the debt ceiling in its failure to mitigate the effects of a deleveraging private sector.