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...
Is this the long way around US securities becoming a more "risky" investment?
ReplyDeleteMatt---possibly...BUT as I am fond of saying in class risky "relative to what"...The bond market has not responded AT ALL so far. Usually any reponse builds over time and we would see an upward movement in Treasury interest rates, but we have not as of yet. In other words, there has been no telegraphing of where interest rates might go..I would say that is a good thing at this point. I read something today suggesting people BUY the Treasuries when (if) they are down because they most assuredly will go back up. I am not smart enough to know. The bond market is a powerful market and if you believe in conspiracy theories, the financiers will "not allow" Washington to default. Sounds like an Oliver Stone movie plot.... :) Thanks for responding and keeping your head in the "economics game"....
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