After A U.S. Treasury Scolding In 1996, Rates Headed Higher, For A While

If you watch the bond market, you might have thought that yesterday's announcement from Standard & Poor's of a "negative credit watch" on bonds of the U.S. Treasury, because Washington is being dopey about reaching a budget agreement, would have shocked bond prices. But it didn't, and yesterday's action shows us what an efficient, calculating, all-knowing machine the global bond market is.

To summarize yesterday's news, Standard & Poor's said it was disappointed in the progress being made to reach a constructive long term federal budget. They didn't actually downgrade the U.S. Treasury from its coveted and essential AAA rating, but they did put Congress on probation.

Bonds were down sharply on the initial news, and stocks were too: I can't tell exactly but it looks as though the 30-year Treasury was off as much as one percent. Stocks were off about two percent. By the end of the day, however, Treasury yields were pretty much unchanged.

We have a precedent of sorts on this sort of warning from late 1995 and early 1996, another time Congress could not get its act together, and the government limped along with temporary increases in the debt ceiling for several months. That time, it was Moody's that shook its finger, and said it was considering a downgrade on certain issues coming due; when the debt ceiling was raised, however, the Moody's reversed its move.

What was the effect then? There was no debt ceiling for a couple of months, and rates did rise. This graph plots the 10-year and 30-year Treasury yields from 1995 through 1997.

Click to enlarge
Long rates had fallen from about eight percent in early 1995 to six percent early 1996, and stayed there until the credit watch was announced in late January. They started rising, and when a new debt ceiling was passed at the end of March, when the 30-year yield reached 6.67 percent.

But the new debt ceiling and the end of the mini-crisis didn't stop rates from rising: they topped out in late 1996 at about seven percent on the long bond, and a half-point lower on the 10-year. It seems something other than the credit watch was at work.

More to the point on yesterday's announcement, and the lack of reaction in the market, is what a very smart guy told me this morning. Seriously thinking the U.S. would default on its bonds is misguided, he said, because the government can always print the money if it has to. He added, however, that it might be a useful catalyst to bringing some fiscal sanity to Washington.