Yesterday, a small auction of Treasuries was poorly subscribed, as investors are starting to avoid U.S bonds. Last night, one of the three credit ratings firms, Fitch, announced the United States was being placed on “negative credit watch,” the last step before stripping us of our AAA rating. Standard & Poor’s has already stripped us of that rating, based not on our ability to pay but on our inability to govern.
Interest rates that we pay on short-term Treasuries have risen, while falling on long-term Treasuries. This is called a “flattening yield curve” and is usually a predictor of recession.
Traditional interest rate analysis begins with the “risk free rate” (RFR), which reflects inflation and the demand for bonds versus other asset classes. To that RFR, you add something to reflect risk of not being repaid, called the risk premium. Whether you are comparing AAA corporate bonds with junk bonds, you start with the RFR and add a small risk premium for AAA corporate bonds and a large risk premium for junk bonds. That’s why junk bonds carry higher interest rates than AAA corporate bonds.
Around the world, the RFR has universally been U.S. Treasuries. Now what, the RFR is no longer risk-free or is it? Investors are avoiding short-term Treasuries, but buying longer-term Treasuries in the belief we’ll eventually get our act together.
Many pundits are predicting our interest rates will rise sharply, because the RFR will rise, but that ignores the power of the Fed to keep interest rates low with quantitative easing. Over the long term, the RFR will rise but no time soon.
Another piece falling into place are the lawyers circling Congress. If interest payments are made while Social Security payments are not, there are legions on both sides saying that is an unconstitutional prioritization of equally-binding laws. I don’t venture a legal opinion, but, as an economist, it is better to pay the interest.
Treasury workers are already hiding behind technology, saying they cannot technically pay interest without paying entitlements. They’re getting their excuses ready.
Another piece is the sophisticated cash-flow analysis for the Treasury, which predicts the end-of-the-world tomorrow. Goldman Sachs predicts it will be next week. Who knows?
The most annoying piece is the international ridicule. China has called for the de-Americanization of the world, as America has proven that democracy is a joke.
Still, Wall Street remains optimistic that the debt ceiling will be raised and default avoided, as the futures market indicates a nice rally today. I think they’re right . . . until we do all this again in a few months!