A lot of people expect yields to skyrocket on a debt ceiling impasse that causes a government shutdown. John Brynjolfsson is leaning the other way. His view is that a shutdown would signal greater weakness in the economy and cause Treasury yields to fall even more. When he spoke on Tuesday to Bloomberg, he noted that Treasuries seemed range-bound in the 2.95 to 3.00% yield range. As I write this with the debt ceiling fiasco still continuing, Treasuries are rallying and yields have broken through to the downside at 2.9440%.
Here’s what I make of John’s commentary: when people ask What Does Wall Street Want? they are usually thinking about shares. A debt stalemate is bearish for shares because it means much lower government spending and therefore lower aggregate demand, which negatively impacts earnings. But, for bonds, this is bullish because it suggests permanent zero at the Fed, despite the policy rate being over 300 basis points below the headline inflation rate, an unprecedented level of financial repression in the US. That means interest rate expectations will ratchet down and the yield curve will flatten – even with the attendant costs of a downgrade and shutdown.
A lot of people think a stalemate would mean default. That’s a possibility. However, I think this is unlikely. More likely, we would see a selective default whereby the US government would either have to do what California did when it couldn’t pay its bills and issue IOUs or it would have to prioritise payments. My sense is that the bonds themselves will be paid first. I reckon Secretaries Clinton and Geithner have already informed the Chinese of this.
Listening to John Brynjolfsson, I hear the same kind of logic behind what he is saying. Video below
Other government expenditures will not get paid and that means a hardship for those who expect the money, whether companies doing business with the US government or people receiving services and benefits.
If the stalemate were to last more than a few days, a double dip recession would be a lock and that would be extremely negative for shares but still bullish for bonds. It would also mean that tax revenue would be negatively impacted, making the deficit much bigger. The potential for bank failures from losses crystallised from residential and commercial mortgages would increase significantly. So, from a risk standpoint, that means you want to avoid banks and cyclicals in particular. Read David Merkel’s post “Where to Hide?“ for more thoughts on this.