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Why Failure to Reach Debt Deal Could Actually Be Good Thing

Failing to raise the US debt ceiling could have at least one desirable casualty: the bond vigilantes who are betting that Congress will keep on racking up debt with endless abandon.

U.S. Savings Bonds
U.S. Savings Bonds

Much panic has been fomented over what would happen if the borrowing limit stays put, but little focus gets paid to what good could come of it.

In an analysis from Bob Janjuah, fixed income analyst at Nomura International, lack of a debt deal would cause short-term pain but ultimately signal that Washington is serious about curbing its free-spending ways.

“The knee-jerk reaction would be to sell USTs (Treasurys) and USD (the dollar), but no deal on the debt ceiling would I feel ultimately send a very positive message to the bond vigilantes that the US is serious about getting its fiscal house in order,” Janjuah wrote in a note to clients.

Bond vigilantes sell or short-sell—generally through exchange-traded funds—government bonds on the belief that the issuer is not of good credit and will cause bond pricesto fall and rates to rise. The effect for the governments under attack is rising yields and more expensive costs to finance debt.

Over the past year or so the vigilantes have had no shortage of targets.

The European periphery is littered with bad credit risks, from Greece to Portugal to Spain and, now, to Italy.

The U.S. could be next if it extends the debt ceiling without coming up with a workable plan to reduce runaway debt and deficits. Moody’s and Standard & Poor’s already have the country under notice of a possible credit downgrade.

In fact, Janjuah concluded that the vigilantes performed a service in Italy, driving up rates and sending a message—ultimately heeded by Rome—that unless it took substantial measures to curb spending the nation’s debt market would come under attack.

Italy conducted a series of auctions Thursday on long-term debt that, while producing the highest yields in three years, ultimately went off in an otherwise orderly fashion. Later in the day, the Italian Senate passed an important series of austerity measures, giving hope that the country would escape the guillotine that appears to be waiting for its debt-laden sister countries.

“As for Italy, it seems clear to me that the market does not want to attack Italy out of any speculative spite,” Janjuah said. “Rather its message to Italy is to trust (finance minister) Giulio Tremonti to deliver the kind of fiscal outcomes that are needed to return Italy to the core, rather than have it flirt with the periphery.”

Continued progress due to bond vigilantism could separate Italy, then, from the other so-called PIIGS (Portugal, Ireland, Greece and Spain are the others).

The rest of the group has been attempting to enact austerity measures while forestalling the seemingly inevitable restructurings necessary to cut down their debt costs and begin returning to stability.

“As long as the sensible fiscal policies of the last decade are further built upon, I am confident Italy can exit the eurozone debt crisis in acceptable health,” Janjuah wrote. “However, I do not think the same is possible for Greece, Ireland or Portugal.”

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