We keep hearing about this big disconnect between the debt ceiling (which looks increasingly less likely to be raised by August 2) and the Treasury market, where rates remain at lock bottom.
The typical answer: Well, Wall Street figures something will get done at the last second, so there’s really no reason to worry.
Sure, this seems like the most likely outcome to a lot of people, but this probably isn’t capturing the whole dynamic.
See: The most likely outcome if we hit August 2 without a deal is that the Treasury finds some way to prioritize payments: Shut down most of the government, and continue making coupon payments, which it can theoretically do easily, because incoming revenue more than covers interest.
So not only will bondholders likely get paid, the bracing, instant austerity will slow the economy, causing a rush out of stocks and yep… into Treasuries! So not will an economic slowdown produce a boost Treasuries, the lack of Treasury issuance post-Aug 2 means there will be a special scarcity value for the most liquid safe-haven asset in the world!
Unless we actually got to the point of default-0default (where the government was running out of enough revenue to cover interest) — something that wouldn’t happen for a long time, and something that’s likely never to happen since the economic weakness of a shutdown would likely force debt ceiling action — there’s no good reason to sell Treasuries, and actually a very good reason to buy them.
If the US government defaulted on its debt, it would probably create the mother of all panics in every market, and there just isn’t enough gold or Swiss Franc of Singapore Dollars to satisfy the panicked asset dumpers, and it’s conceivable that even then Treasuries would rally like they always do in a mega-panic.
That would be ironic, to say the least.
PS: One more thing to think about is that there’s no such thing as the Treasury market in isolation. Treasuries are one asset class that competes with other asset classes (like stocks) for capital, so it’s very conceivable that there are some investors panicking over the debt ceiling, and buying Treasuries, which would easily explain lack of debt ceiling deal and Treasury rally.