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What Happens to Bonds If the Debt Ceiling Isn't Raised?

Most folks on Wall Street assume that investors in U.S. government debt will grow skittish as the deadline for raising the debt ceiling approaches, pushing up interest rates. If the debt ceiling is reached without an agreement to raise it, many think interest rates will skyrocket for fear of an impending default.

But things might go exactly the opposite way.

From Business Insider:

If the debt ceiling isn't raised, the way for the U.S. to avoid default is to cut off all discretionary spending and funnel that money to interest payments.

As Matt Busigin of Macrofugure points out, an end to all discretionary spending would slam the economy and be wildly deflationary which would... be a gigantic boost for bonds, sending yields sharply lower.

But markets don't just respond to economic conditions, they attempt to anticipate them. If Busigin is right, we should expect a bond rally even before we reach the debt ceiling. And the more contentious the debate becomes, the more bonds should rally.

As long as are forecasting into the unknown, we might as well take this a step forward. Republican lawmakers will notice that the bond market rallies every time they talk tough on the debt ceiling. This could encourage more recalcitrance on the issue.

In short, the bond rally anticipating the debt ceiling not being raised could contribute to lawmakers resolving not to raise the debt ceiling. It's reflexivity all the way down.

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