Worries on US debt ceiling bubble beneath surface

Friday, 8 July 2011 01:16 - - {{hitsCtrl.values.hits}}

(Reuters) - As the standoff over raising the U.S. government’s borrowing limit enters its final month, it’s becoming harder for investors to avoid thinking the unthinkable: the world’s most trusted borrower could soon renege on its debt.

The U.S. Treasury says it will be forced to default on its obligations if Congress does not raise the $14.3 trillion debt ceiling, which caps how much it can borrow, by Aug. 2.

The Treasury has not specified which bills it wouldn’t pay, but the prospect of its missing interest or principal payments on any outstanding debt is a terrifying one for Wall Street.

Even a temporary default would erode the United States’ status as the world’s most powerful economy and the dollar’s role as the dominant global currency.

“It would be catastrophically bad to tell the world that the United States is willing to default on its obligations,” said Gregory Whiteley, who helps manage $12 billion in assets at DoubleLine Capital in Los Angeles. “Even if the default only lasted a few days, the precedent would be set.”

A default would undermine confidence in Treasuries, the world’s safest asset and the benchmark for the global bond market, particularly if ratings agencies were to cut the United States’ prized AAA credit rating.

If investors start demanding higher returns for holding riskier U.S. debt, the rise in bond yields would crank up borrowing costs for consumers and businesses. This in turn could tip a still fragile economy back into recession.

Republicans in Congress want the White House to commit to deep spending cuts before lifting the ceiling while Democrats favor adding tax increases on the wealthy. Talks collapsed two weeks ago, and compromise seems far off. For details, see

Even so, investors are not panicking. The benchmark 10-year Treasury yielded 3.09 percent on Wednesday. While above its 2011 low of 2.84 percent hit last week, that was still far below where it would be if markets felt default was imminent.

“I don’t think the majority of Congress is so stupid as to visit an actual default on the United States,” said David Kelly, chief market strategist at JPMorgan Asset Management. “Their constituents would never forgive them for playing fast and loose with the credit-worthiness that it took 230 years to build up.”

But as the deadline nears, markets may grow more restive.

Standard and Poor’s told Reuters last week it would waste no time cutting the top-notch U.S. credit rating if Treasury missed a $30 billion debt payment on Aug. 4.

Robert Tipp, chief investment strategist at Prudential Fixed Income, with $240 billion in assets, said long-term interest rates could swiftly rise by up to 50 basis points.

Based on the projected budget deficit, that amounts to an extra $70 billion in interest costs -- a fairly hefty price to pay for a country already facing a large debt burden.

Robert Brusca, chief economist at Fact and Opinion Economics, reckons a default could be a lot more costly, knocking Treasury prices down 5 to 10 points in a day -- a violent and unusual move. “This could be a horror show.”