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.


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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On the debt ceiling deadline: If Reid’s plan incorporates McConnell’s ideas, Democrats will have now FULLY – not partially but 100% – capitulated to Republicans. It stinks to high hog heaven, and House Republicans will still vote against it. Reid might even see a mini party revolt of his own.

On the yield curves: It feels as though you needed a second chart to demonstrate what’s going on with the yields:

Posted by GRRR | Report as abusive

“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.”

Reaching a bit here aren’t you? There could be any number of reasons that yields are falling. One could argue just as easily that yields should rise as a hobbled economy will cause Congress to throw more money at the problem and further exacerbate the deficit problem. Or one could argue that in failure the bond vigilantes see a real solution to long-term fiscal problems arising from the ashes and so see a buying opportunity. Or one could posit any number of other explanations for falling rates. But that would be pure speculation.

Posted by TomLindmark | Report as abusive

This “crisis” was manufactured by the “rebirth” of my once great party… and I type that with the maximum possible level of spite. After spending money at a pace and scale never before seen while in control of the house, the senate, and the presidency… after my party cut taxes on the eve of a 10 year war of our choising… NOW we need to hold the line on the debt? This would be comical if not for the consequences which are comming.

I can say with absolute confidence that this crisis of choice will NOT be responsible for the loss of our AAA credit rating and the higher rates the could result. Consider the difference between whatever small trigger releases an avalanche and the underlying conditions necessary for an avalanche to take place. It’s not the last straw that breaks the camels back… that camel wasn’t going to make it to far even before that one last straw.

The United States will not lose our AAA rating because of the circus we’re seeing this weekend in Washington. We will (and should) lose that highest rating because we are a nation which cut taxes just a few years prior to the onset of the baby boom hitting entitlement eligibility.

We are a nation that knew we could not afford the promise of a roughly 20 year goverment subsidized vacation for all citizens… yet instead of making gradual changes to reflect the mathmatical realities of modern longevity… we passed another new mega-benifit with the percription drug bill.

We will lose are AAA credit rating… but not because of anything that happened in the last 6 months.

Posted by y2kurtus | Report as abusive

GRRR:much better chart! Felix should scrap his and use yours.

Posted by Greycap | Report as abusive

You need to mention prices and not yields. Someone could reasonably think that going from 0.08% to 0.16% is a doubling of yield! However, the price difference on $1000 nominal 1-month bond from 0.08% to 0.16% is 7 CENTS. Think about if you have $1000 in your pocket, of various denomination bills and coins. Do you notice $0.07 lost? There may be some arbitrage/interest rate hedge trade that could yield some profit using massive leverage, but I dont’ see any practical importance in 1-month yields moving from .08% to .16%.

Posted by winstongator | Report as abusive