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No Super Committee Deal? Bond Yields Set to Drop

The news that the congressional super committee would not reach a deal to cut $1.2 trillion from the federal budget will likely lead to lower yields on U.S. government bonds.

It's now a familiar, if counterintuitive dynamic. Worries that U.S. lawmakers will not be able to negotiate a deal to reduce the federal government's budget deficit lead investors to buy bonds. Instead, the automatic cuts agreed to this summer will kick in.

Why does that happen? Well, worries about deficits make people worry about the economy more broadly. Risk assets, including stocks and corporate bonds, seem less attractive, and risk-free assets appear more attractive. Since the U.S. government issues debt in its own currency, on a yield-to-maturity basis, our bonds are one of the only risk-free assets in the world.

The governments under pressure in Europe do not enjoy this advantage. They issue debt denominated in euros, which the individual governments do not control. They must raise euros from elsewhere — either through taxes or additional borrowing — in order to fund their deficits and sovereign debt obligations. They cannot create the currency needed to meet their obligations.

Of course, the U.S. ability to issue debt is not without cost. Creating new money to fund budget shortfalls runs the risk of creating inflation . But right now, inflation does not seem to be a serious threat.

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