Adventures with yield curves, debt-ceiling edition

By Felix Salmon
July 30, 2011

Bill Dowd emails to ask about short-term Treasury yields, which finally seem to have noticed the debt ceiling debate in recent days:

When treasury yields are discussed in the media, everyone seems to default to talking about 10-year bonds. The yields on those remain well below 3%, and indeed have fallen a bit today. On the other hand, yields on 1-, 3-, and 6-month bonds have increased considerably today, with the yield on the 1 month bond exceeding 17bp (up nearly 50% today). It seems to me that there’s no concern among investors about America’s long-term debt, just about its ability to get its act together in the short term. Of the three maturities I noted above, 1-month bonds are the highest. It seems as though investors are pricing in the possibility that payments might be delayed.

I put together a little chart from this page, which isn’t a thing of beauty; for one thing, in order to show changes at the short end of the yield curve, I had to switch the y axis to a logarithmic scale.

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What you’re seeing here is, indeed, a sharp rise at the very short (1-month) end of the yield curve. And all the way out to one year, yields on Friday are significantly higher than they have been for a long time.

Still, a couple of points are worth making. For one thing, a yield of 0.16% is still minuscule, and doesn’t imply any real credit or payment risk. The fact that the yield curve is now inverted between 1 month and 3 months is interesting, but it’s basically an indication that the markets are now paying attention. The dog has pricked up its ears; it has yet to actually do anything.

Secondly, and this isn’t very obvious on the chart, we’re seeing an even bigger drop in long rates than we are an increase in short rates. The yield on the one-month bill rose 6bp from 0.10% to 0.16% on Friday; the yield on the 10-year bond dropped by 16bp from 2.98% to 2.82%.

And thirdly, the yield curve is only inverted between one and three months. From 3 months on in, its still got a nice upward gradient to it. If there’s worry here at all it’s about possible payments problems over the next month; there’s no indication of concern about a debt downgrade coming in the next six months to a year.

The next big debt maturity comes at the end of August, and it makes sense that if you’re only getting 0.16% yield in any case, you might as well just hold cash instead of very short-dated bills. But even cash has to be on deposit somewhere, and that somewhere is a place with non-zero credit risk. (Unless you’re a bank, in which case you can hold cash on deposit at the Fed.)

I’m getting really rather worried about the debt ceiling. This is now the second consecutive last possible weekend to get something done, and it frankly looks as though the August 2 deadline is all but certain to be missed. Meanwhile, the White House is pouring cold water on the idea that we might get saved by the 14th Amendment.

People like Tom Davis are drawing parallels to the TARP vote, which is understandable, but also dangerous:

“He’s going to have to pass it with Democratic votes. That’s going to be a tough decision, but he doesn’t have any choice at that point, particularly if the markets are reacting,” said Tom Davis, a former House Republican leader from Virginia. “That’s the position they’ve got themselves in.”

But, he added: “The stakes are much higher here. If interest rates start spiking up, it’s going to cost us a lot more than anything you could save. They’re playing brinkmanship with our credit rating. That’s not very smart.”

Mr. Davis recalled his vote in late September 2008 for the $700 billion Troubled Asset Relief Program that President George W. Bush sought to rescue a financial system near collapse. “I hated TARP, but no one had a better alternative,” he said.

But most of his Republican colleagues opposed the rescue measure and helped defeat it, sending the stock markets tumbling even as the vote was taking place. That reaction forced the Republicans to retreat, and days later a bailout bill carried on a second try.

The problem here is that this is much more serious than the TARP vote. With TARP, a no vote sent the stock market down, and then a yes vote largely rectified the damage done. The debt ceiling doesn’t work that way — a failure to get it raised will have enormous long-term consequences, much more serious than a twitch in the stock market, which couldn’t be rectified by a subsequent change of mind by Congress. Even in the worst-case scenario, the debt ceiling is going to get raised somehow, sooner or later.

And this I think is what we’re really seeing in the yield curve. Never mind twitches at the very short end — look at the speed with which long-term rates are going down. That’s a sign of pessimism about long-term U.S. growth — an indication that Congressional failure to raise the debt ceiling will hobble the economy for the next decade. Thanks, guys.

Update: In the comments, GRRR puts Treasury’s yield information together in another way, by having two different y-axes. I like this:

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