U.S. Treasury Secretary Geithner has warned that delays in extending the U.S. debt ceiling may cause irreparable harm. While borrowing costs for the U.S. government have not yet risen, irreparable harm may have already been done to the U.S. dollar and its status as a reserve currency. Ironically, it’s not a plunging, but a rallying bond market that is a symptom of the problem. Let us explain.

First, no one really knows how the markets will behave should the U.S. delay servicing its debt. Most observers believe that a) the Treasury has a big bag of tricks to continue servicing the debt; and b) politicians will play a game of chicken, but eventually do what they always do: agree to spend more money. Some have even suggested that a derailment of the bond market may not be the worst outcome, as it forces action on the deficit now rather than later, arguing that in the long-run, this would be a positive development. That said, we don’t know how the bond market will react; but we do know that policy makers are playing with fire, and when you play with fire, you may get burned.

For the time being, there is a more imminent problem building in the markets that may have long-lasting effects. At this stage, the U.S. government may roll existing debt, but cannot issue new debt. This has created a situation where fear may be spreading that there simply won’t be a large enough supply of debt to meet investor demand. While this sounds like an odd problem to have, we have recently witnessed a rather unusual level of investment flows, with money piling into Treasuries. As of this writing, investors receive a paltry 0.04% annualized return on their money for giving Uncle Sam a 3-month loan. That’s a third of the yield available at the beginning of the year, when 3 month U.S. Treasury Bills yielded an annualized 0.12% (already a severely depressed yield): Continue Reading>>>