Interest Rate Fears Rise as Debt Limit Deal Fades
Policy + Politics

Interest Rate Fears Rise as Debt Limit Deal Fades

The Fiscal Times

The economy and financial markets are bracing for three months of interest rate anxiety as Washington politicians play chicken with the debt ceiling, which must be raised sometime around mid-July to avoid a partial shutdown of government operations.

Treasury Secretary Timothy Geithner played the default card in his early April letter to the Congressional leaders of both parties.  He warned that “if Congress failed to increase the debt limit, a broad range of government payments would have to be stopped, limited or delayed, including military salaries and retirement benefits, Social Security and Medicare payments, (and) interest on the debt.”

While he expressed confidence during his appearances on last Sunday’s television talk shows that a deal will be reached, he also insisted on separating negotiations over future spending plans from the debt limit vote.

For their part, House Republican leaders, under pressure from newly elected Tea Party members, are vowing to withhold support for lifting the debt limit until the president agrees to a long-term plan that slashes future government spending, reins in entitlement programs, and avoids raising taxes. The Tea Party’s emerging political strategy, hinted at by Sen. Rand Paul, R-Ky. on Sunday, is to call for the government to continue making interest payments on existing debt, which would preserve the nation’s credit rating, while stopping payments for other government programs to stay within the debt limit.

“There is another alternative, and that is that we send the message to the president through legislation that says: ‘You know what, Mr. President? Don’t default, but pay the interest out of the revenue,’” Paul said on CNN’s “State of the Union.”

The government will bump up against the $14.3 trillion annual debt ceiling sometime around mid-May. The Treasury Department has a number of accounting and borrowing strategies that can postpone running out of cash for several additional months.

And that has many of the business economists who monitor events in Washington fretting that the fragile economic recovery –estimates for economic growth in the just concluded first quarter are being ratcheted down to as low as 1.5 percent – could be aborted if Republican leaders in Congress and the White House engage in three months of brinkmanship before reaching an accord.

“It’s going to push back some investment decisions whether interest rates go up or not,” said Ken Simonson, chief economist for the Associated General Contractors of America. Construction activity nationwide remains at 1999 levels, and the industry still has 2.5 million fewer people working than before the Great Recession, the first time since 1933 when economic activity in non-inflation-adjusted dollars actually declined. “We’re going to see people get more cautious over the next three months because of the uncertainty.”

Commercial and residential construction has failed to respond to the record low rates of the past two years. The ten-year Treasury bill hovered around 3.3 percent this week, and even fell slightly after Standard & Poor’s placed U.S. debt on its “watch” list because of ongoing fiscal problems. Rates for a 30-year fixed mortgage remain well below 5 percent.

Global Glitches Threaten Recovery
But low rates may be a short-lived phenomenon that has more to do with broader economic events around the world than the deteriorating political situation at home. China raised capital requirements on its banks Sunday in an effort to tamp down inflation and growth; Japan remains inwardly focused as it prepares to rebuild the northeast coast devastated by the March 11 earthquake and tsunami; political turmoil across the Arab world has sent oil prices to over $100 a barrel, which acts like a tax on consumer spending; and the weaker countries in the European Union remain mired in their own debt crises.

This toxic stew of international issues has led investors to once again seek out what they consider the safest investment in the world, U.S. government bonds. “The broad ‘risk-off’ trade was to go to Treasuries,” said Alan Levenson, the chief economist at T. Rowe Price Associates, which keeps about a quarter of its $480 billion in corporate and government bonds. “We may see more volatility in the Treasury market because of (the debt ceiling) issue, but the economy will still play the dominant role.”

"Could you imagine what would happen
if businesses had to pay 2 to 3 percentage
points more.... It would cause a double dip.”

Most economists have been projecting that long-term rates will go up 30 to 50 basis points (0.3 to 0.5 percent) by year end because of a strengthening economy and the expiration of the Fed’s quantitative easing policy (QE2) at the end of June. But now many are worried it could happen sooner and rates could go higher because of political turmoil, even if the economy continues to weaken.

Bonds May Take the Biggest Hit
A sell-off of government bonds along the lines already pursued by PIMCO, whose founder, Bill Gross, said he exited the U.S. Treasury market earlier this year, would depress bond prices and raise rates, which go up when bond prices go down.  “Bond traders are a spooky bunch,” said Steve Bell, a budget analyst at the Bipartisan Policy Center who spent years on Capitol Hill as well as 10 years trading bonds for the now defunct Salomon Brothers.

“If they start playing games with the debt ceiling like passing a number of short-term extensions, you’ll see people exiting the market despite their desire for safety.”

He estimated failure to increase the debt ceiling could raise long-term rates by 1 ½ to 2 percentage points over the next six months. “Housing is flat on its back now,” Bell said. “Could you imagine what would happen if small and medium-sized businesses had to pay 2 to 3 percentage points more, or credit card debt or the rate you pay for your car went up. It seeps into every type of economic activity. It would cause a double dip.”

Of course, not everyone is afraid of higher rates. Some people – savers in particular – are rooting for them. “The rates on money market funds two years after the end of the recession are at least four percent lower than normal,” said William Ford, the former president of the Federal Reserve Bank of Atlanta who now teaches economics and finance at Middle Tennessee State University. “There’s $600 billion of interest not going to elderly savers.”

Related Links
Every Discussion on QE and Interest Rates Must Include This One Chart (Business Insider)
After a US Treasury Scolding in 1996, Rates Headed Higher, For a While (CBS Money Watch)
Thought the financial crisis was bad? Wait till the debt ceiling caves in (The Washington Post)