Government Bond Yields And The Debt Ceiling

Includes: IPE, TIP
by: John M. Mason

It is remarkable how little effect the looming debt ceiling crisis has had on longer-term US government bond yields. Since the shut down of the government on October 1, the yield on the 10-year Treasury bond has risen by less than ten basis points.

On September 30, the 10-year Treasury bond closed to yield 2.616. Around noon on Tuesday, October 15, this security was trading to yield 2.722 percent.

No strong emotion here. No concern with a default or subsequent financial crisis that many fear-mongers have been talking about.

In terms of the yield on the 10-year TIPS, the yield has moved from 0.416 at the close on September 30 to 0.467 when markets closed yesterday.

The same structural relationship exists between the inflation-adjusted yield and the nominal yield. In fact, the calculated value for "inflationary expectations" has not changed at all since September 30, remaining at 2.2 percent.

The rise in interest rates through the summer continued into the fall with the 10-year Treasury security yielding right around 3.00 percent on September 5. The TIPS yield was about 0.888 at that time, with the derived "inflationary expectations" still in the 2.1 percent range.

Thus all the movement in longer-term interest rate yields since the beginning of September has been in the "real" yield and not just in the nominal yield.

I have previously argued that the movement in the yield on the TIPS from a negative figure to a positive one was primarily the result of the flow of money leaving the "safe haven" of the United States Treasury market and returning to European markets that had settled down over the past six to nine months.

Some of this rise in the yield on TIPS may have come from the possibility that the Federal Reserve would begin to "taper" its securities purchases, but, to me, this was just a minor part of the rise in rates. Given that the drop off in the TIPS yield since the Fed declared that it was not going to "taper" its purchases has only been about 40 basis points, I can agree that some of the rise in rates was because of the changes in expectations about how the Fed would behave.

Now, we look again into the future.

Scenario one: the US government defaults on its debt.

I don't think so. The government will kick the can down the road.

Scenario two: The US government does not default on its debt. As the financial markets continue to strengthen in Europe, more "safe haven" money will flow out of the United States and back into European securities. It is remarkable how the yields on the bonds of Italy, Greece, Portugal and Ireland have dropped relative to the yield on German bunds. With the re-election of Angela Merkel in Germany and the continued, albeit slow, recovery that is now taking place in the economies of Europe, confidence is growing in the sovereign debt of the continent.

If scenario two occurs, more and more money will leave US financial markets and the nominal yield on the 10-year Treasury security will rise.

And, the Federal Reserve will not be able to stop it.

I believe that there will be no change in "inflationary expectations" in the near term. For the time being, price inflation seems to be under control in the United States and there will not be any "surprise" statistical releases that will change market expectations. Hence, I believe that "inflationary expectations" will remain somewhere around 2.2 percent.

What will change will be the yield on 10-year TIPS. This yield will rise from where it is, around 0.467 percent, and will move through 1.00 percent, 1.50 percent, and will head on toward 2.00 percent.

Thus it is my belief that the yield on the 10-year Treasury security will move toward 4.00 percent. The time horizon of this move I believe will be in the six- to nine-month range.

It is my belief that if scenario two unfolds, the Federal Reserve will be able to do very little in combating this increase. In fact, if this scenario does work out, the Federal Reserve will be caught in a real policy dilemma. It is going to have to begin to "taper" its purchases. But, to begin to "taper" them in the face of already rising longer-term interest rates is going to be very difficult and will perhaps bring on some political abuse because of its need to "taper" at this time.

This is going to be a tough time for the Fed. Now, the consequences of all its former monetary ease are going to come together. Janet Yellen is going to have a tough row to hoe.

Obviously, Europe could fall apart... again. The world economy could tumble. And so forth and so on. Given these possibilities, it is my belief that scenario is still the most probable case.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.