Sunday, July 24, 2011

Very short lesson on what might happen in a few hours in the US Treasury market if a debt deal is not made (or even if one IS made)...

The Federal government borrows money by issuing US Treasury notes/bills---basically IOU's. I am going to use a very simple example to show how the market for US Treasuries may be affected by the failure to raise the debt limit. Keep in mind these numbers are NOT reflective of true market prices. The math is easier for me that way...

If the govt wants to borrow money they issue one of these Treasury Notes/Bills.  Assume the face value of this Treasury is $1,000 and the current market price for this Treasury is $900 (remember, this does NOT reflect the REAL market AT ALL!).  You buy this bond for $900, so the government in essence has borrowed $900 to spend on whatever they want to spend it on. When you redeem it at maturity you earn $100 over what you paid for it.  Your effective interest rate then was 11.11% ($100/$900 x 100). 

Now, assume the debt limit is not raised and there is perception/eat that the US govt will default on its debt obligations. What is going to happen to the price of US Treasurys now and in the future? We should expect the price to DECREASE as the Demand for them DECREASES. 

Now, for the govt to attract borrowers they will have to LOWER the price of the Treasury to entice people to buy one.  Assume the price is now $800 for a $1,000 Treasury.  So, now the effective interest rate is 25% ($200/$800 X 100)!!

This is what it means when you hear that the borrowing costs for the US government might increase if a deal is not reached.  They will have to accept LESS for each bond issued and pay MORE when they are redeemed.

I hope this helps when the stuff hits the fan in a few hours. The first thing that will be affected will be the price of US Treasuries in the market. 

Note: The demand may fall as I described for US Treasuries BUT the Supply of Treasuries already in circulation could (will ) increase as investors dump them. If the supply increases it has the same effect as demand decreasing, hence the same downward pressure on the price and effect on borrowing costs...
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