Washington is about to get insane again. Immense disruptions lurk. Only a few legislative days before government agencies run out of money. The new fiscal year is poised to start October 1, and there’s no mechanism for funding the government. Friday morning, the House GOP passed a law that continues to fund the government through the end of December—but only if the Senate and President Obama agree to defund implementation of the Affordable Care Act. Worse, in less than a month the Treasury Department will run out of authority to issue new debt. And House Republicans say they’ll only increase the debt limit if (wait for it!) Obama agrees to delay implementation of the Affordable Care Act.
So the U.S. government is about to run out of money and may announce its unwillingness to meet legal debt obligations. What should you do with your money in the face of such impending calamity? Why, buy U.S. government bonds, of course.
The U.S government bond market, $12 trillion deep, is the most liquid, safe, and vital of all global financial markets. Savers, central banks, companies, and institutions around the world stash short- and long-term savings in government bonds. In theory, playing havoc with the government’s finance and creditworthiness should be the equivalent of throwing toxic chemicals into the pool. Everybody would run for their lives.
But both the stock and bond markets have been—and remain—generally complacent. That’s in part because other Washington-based activity, like the Federal Reserve’s announcement this week that it would continue its aggressive bond-buying activity, matters much more to markets than anything Congress can do. Political nuttiness is just one of many factors that affects the trajectory of financial markets.
Indeed, investors have learned to ignore the lunacy and approach D.C. grandstanding with a certain amount of cynicism. “We’ve cried wolf with the debt-ceiling problem in August 2011 and the fiscal cliff back in January,” said Gregory Valliere, chief political strategist at Potomac Research Group. “These things always seem to get resolved, even though it’s messy.” The shutdown is a far less daunting threat than the debt ceiling, which is still several weeks away—i.e., several lifetimes in today’s Wall Street of high-frequency trading. “But even then, the idea that we’d default on the debt is still very unlikely,” Valliere added. The prospect of the U.S. not paying its bonds is so loony, so scary, and so unthinkable that markets are refusing to countenance its possibility.
Given this mentality, not only is it perfectly safe to keep buying government bonds, it may make financial sense. Government shutdowns, fiscal restraint, and manufactured crises are generally bad news for stocks and good news for bonds. Should the sequester continue, or if Obama agrees to more budget cuts as a condition for increasing the debt limit, the American economy would slow. U.S. companies that depend to various degrees on government contracts, subsidies, and indirect payments—defense contractors like Lockheed-Martin, technology firms like IBM and Cisco, contractors like Booz Allen Hamilton—would have to reduce their forecasts. That’s bad for a particular group of stocks.
But the repeated fiscal clashes also have been bad news for stocks generally. For the last couple of years, the U.S. government has been a source of immense fiscal restraint, removing cash and consuming power from the economy through higher taxes and lower spending. The more it continues, the more it weighs on the ability of companies to hire and consumers to spend. That’s bad news for stocks, for the economies of foreign countries whose factories feed the American consumer (hello, China!), and for commodities. All things considered, lower levels of U.S. economic activity tend to lead to lower demand for grains, steel, and oil. And what do investors do when the economy is slowing? They buy government bonds.
There’s another way in which the continuing drama over budgets and spending helps bonds. I’ve long noted that this is the Golden Age of Deficit Reduction. Thanks to the sequester, the gradually improving economy, and higher taxes that went into effect in January, the U.S. has experienced an epic, unprecedented amount of deficit reduction in this past fiscal year. The deficit is expected to decline from $1.089 trillion in fiscal 2012 to about $700 billion in fiscal 2013, a decline of nearly $400 billion. Continuing spending at sequester levels, and reducing them further (one could easily imagine President Obama capitulating to Republican demands for cuts in exchange for a temporary ceasefire in the budget and debt-limit wars) would reduce the deficit further in fiscal 2014. “Whatever finally happens will reinforce this trend in fiscal restraint,” Valliere noted.
And that means the supply of new government bonds will be declining. Treasury is already selling many fewer new bonds this year than last year, and next year it will sell even fewer. So the supply won’t be growing very rapidly. Meanwhile, there’s plenty of cash sloshing around the world looking for a safe haven, which means demand for Treasury bonds could be rising. And we all know what happens to prices when rising demand meets declining supply.
So once again, as D.C. enters a period of fiscal and financial chaos, the smart money will be rushing to purchase financial obligations backed by nothing more than the promise of the U.S. political system to pay.