Debt Ceiling Threat to Risk Free Rate: Is It Real?

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The debt ceiling crisis has an inconspicuous victim, the U.S. bond market. The simple logic is that a U.S. Treasury default on its bonds will cause the bond investors to panic, causing both long and short term interest rates to spike. The U.S. Treasury bond holders will bear the brunt but the default would also cause a ripple effect across the global financial sector. Let’s start with a bit of background on what has been going on since the beginning of 2013.

Debt Ceiling Crisis – A Premature Anniversary of the U.S. Fiscal Cliff Problem

The U.S. government shutdown and the looming debt ceiling crisis remind me of the fiscal cliff chaos over budget sequestration at the beginning of this year. The fundamental tenet of both instances is to narrow down the government deficit through a series of previously enacted law. “The fact that we are here today to debate raising America’s debt limit is a sign of leadership failure. It is a sign that the U.S. Government can’t pay its own bills. It is a sign that we now depend on ongoing financial assistance from foreign countries to finance our Government’s reckless fiscal policies,” said the U.S. President on the senate floor in 2006 (Forbes). The point is that there’s a growing concern among the political parties about excessive government spending and they want to address it by being more fiscally disciplined.

Although being fiscally prudent deserves appreciation, government spending is one of the essential levers to sustain economic growth, with the potential of social and financial returns in the long-term. This indecisiveness of the political parties is driving markets toward a state of unpredictability; especially if the U.S. defaults on its debts because the debt ceiling isn’t raised. The debt ceiling issue is essentially larger than a matter of fiscal discipline and can have far reaching implications. As shown this week, it has been a choppy ride both for financial and fixed income markets.  (To read more about the early 2013 fiscal cliff, see Fiscal Cliff Deal and its Impact on the Energy Sector and A Year in Review – 1 – Hiking up the Fiscal Cliff).

Risk-Free Rates

For the markets, the important question now is – how secure are risk-free rates?

The crisis over the debt ceiling has raised some real doubts on the short-term Treasury bonds being used as a proxy for risk-free rates. Some events have the potential to force us to reevaluate a well-established premise. These are the times when we realize that there’s no such thing as a risk-free financial instrument. Markets were showing signs of panic before the GOP signaled a temporary increase in the debt ceiling. As the possibility of a U.S. debt default is becoming real, fixed income investors are getting deterred and selling off their Treasury Bills, resulting in spike on Treasury bills yield rates (CNNMoney).

Figure 1: Short-term Treasuries are flashing warning signs. Yields have spiked on debt that will mature in the next few months. (Source: CNNMoney)

Other potential factors that may be affecting the risk-free rate could be the nomination of Janet Yellen as the next Federal Reserve Chief (Reuters) and the IMF’s warning on the U.S. stimulus cut (Yahoo News), which can all significantly affect financial and commodities markets. But, the simultaneous nature of all these events causes complications in attributing market movements to the right factors or to make right distribution of affecting factors.

Although the fear over the debt ceiling crisis seems to be fading away, the sequence of events has made investors adapt to a new normal (i.e. frequent political bumps, be it government shutdown, debt ceiling crisis, or the Federal Reserve’s flip-flop on tapering).  Even though the financial markets were going haywire during the budget sequestration at the beginning of this year and the current debt ceiling crisis has continued the unrest, the diversified S&P 500 index somehow is currently up 18.07% YTD (CNNMoney). The last week’s events could be good food for thought for those studying behavioral finance.

Figure 2: The diversified S&P 500 index showing an 18.07% YTD increase. (Source: CNNMoney)

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