Will there be panic in bond market?

A failure to reach an agreement on the debt ceiling by Aug. 2 wouldn't have to result in a default on US bonds. But how would traders react?

By TheStreet Staff Jul 25, 2011 12:08PM

By Peter Morici, TheStreet


As congressional negotiators and the president struggle to obtain a deal to raise the federal debt ceiling, securities markets may soon panic at the prospect of those negotiations failing.


Be clear, the U.S. doesn't have to default on its bonds. After Aug. 2, it still will collect taxes and other revenue exceeding $180 billion per month, and interest payments on the national debt eat up less than $30 billion.


If the Treasury prioritizes expenditures -- as the state of Minnesota did during its recent shutdown -- it could pay interest on bonds, roll over bonds coming due and pay Social Security recipients and many other obligations. But it would be late to many vendors until the debt ceiling was raised or new sources of cash were found.


The U.S. would not be insolvent but, rather, would be in a political crisis.


If Greece or another troubled eurozone nation is late paying creditors -- either bondholders or vendors -- investors are justified to believe it will not be able to make good on all its debts without a restructuring -- a partial default. The U.S., absolutely and without doubt, has the economic resources to pay its debts once the political impasse is resolved, especially since this crisis is precipitated by an elected majority in the House of Representatives -- the political body designated by the Constitution to initiate taxing decisions -- seeking to improve the integrity of federal finances.


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As the Republicans are holding out for a trajectory of future budget deficits that makes the U.S. more, not less, able to pay its debts, the impasse can be broken only by a deal that improves the fiscal outlook of the U.S.


With or without the help of Standard & Poor's and other bond-rating agencies downgrading U.S. bonds for actual or prospective late payment to some federal contractors, stock and bond markets may panic.


Policymakers need not worry too much about equity markets -- those dive and rebound on the hiccups of computer traders and will recover once the bond market stabilizes.


Of greatest concern is that, on or before Aug. 2, SWAP rates on U.S. bonds may start rising precipitously and bondholders may start dumping bonds, lowering their market value and raising their yields and market interest rates. That would raise the cost of capital throughout the global economy, because so many rates around the world move up and down with Treasury yields.


Enter fireman Ben Bernanke.


As the Federal Reservedid during QE2, the Fed can buy up U.S. Treasurys to push interest rates lower -- but don't be afraid of inflation for the moment. Investors who trade bonds for cash will likely hold that cash, as they did the bonds, or dump it into stocks.


Consider money market and other investment funds, foreign central banks and traders who use bonds to post collateral in SWAPS contracts in commodity trades. Instead of holding portraits of George Washington that pay interest, they will hold a likeness of the founding father that doesn't pay interest.

Investors could use those dollars to purchase stocks, but that would be a positive thing, because rising stock prices would dampen the herd instinct to panic -- essentially, it would help restore normalcy to equity markets.


Other bond investments are not attractive or available in sufficient quantity. Euro-denominated sovereign debt issued by AAA-rated France and Germany are burdened by continuing fears about their banks' vulnerability to real and potential defaults in Greece, Ireland, Portugal and Spain. Canadian, U.K. and Japanese bonds simply are not available in sufficient quantities to substitute for the dollar-denominated securities.


Essentially QE3 could materialize and save the day -- that is the most sensible short-term strategy for Federal Reserve Chairman Bernanke and Treasury Secretary Timothy Geithner.


Greenbacks held by investors simply don't fuel inflation the way the Treasury's printing money to pay government bills could. Money printed and sold to investors for bonds doesn't get spent at Wal-Mart or the Exxon station and drive up prices.


The Treasury could print money to pay bills and fully finance the government with the potential to drive up consumer prices. Even that could be benign and, if handled properly, be the most sensible strategy if the impasse lasts more than a week or so beyond Aug. 2.

Simply put, during QE2, the Fed purchased bonds equal to more than 80% of the new bonds sold by the Treasury. It essentially monetized the new debt from November 2010 through June.


The Treasury printed bonds and the Fed printed money to purchase that debt, and it now holds $1.6 trillion in Treasury securities. Those already count against the debt ceiling and could be sold to the public without violating the statutory cap.


Now, the Treasury could print money to pay its bills, and the Fed could soak up the excess liquidity by selling its Treasury holdings. Between the Fed's holdings of Treasuries, and Fannie Mae and Freddie Mac bonds and other securities held by the Fed, this drill could keep the government going and all creditors paid for another 18 months.


In the end, the Federal Reserve and Treasury have potent options at their disposal to head off an immediate bond rout and keep the government going until Republicans and Democrats agree on a combination of tax and spending reforms to strengthen federal finances.


This commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.


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