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Why a default threat won't spike rates

October 4, 2013: 5:00 AM ET

Even in a default, many investors would see Treasuries as safer than stocks.

United States Capitol West Facade

FORTUNE -- As Congress seems nowhere closer to resolving the nation's budget problems on day four of the government shutdown, federal officials have raised fresh warnings the U.S. could default on its debt.

Credit markets could freeze, the dollar's value could spiral, and U.S. interest rates could skyrocket, the U.S. Treasury Department warned Thursday. If Congress fails to lift the debt ceiling, the U.S. would have a financial crisis even worse than the one in 2008.

All this obviously sounds very bad, but it's hard to say what could happen or if we should even believe the Treasury Department. After all, a U.S. default is unprecedented. If Americans believe House Speaker John Boehner and most on Wall Street, the U.S. won't default at all.

But in the off chance it does, investors would likely still buy up the nation's debt, at least for a short while. Bond yields may rise some at first, but not by much -- if anything, they'll likely fall.

MORE: The Republicans' best-funded allies have abandoned them

When the U.S. struggled to raise the debt limit in 2011, investors flocked to safety in U.S. Treasuries. Even after Standard & Poor's stripped the country of its stellar triple A rating, investors pulled out of risky stocks and most commodities and sought liquidity in the U.S. debt market. Yields on the 10-year note fell to 2.32% -- at the time, the lowest level since January 2009.

Of course, the economy in 2013 is far different from 2011. Even then, a default wouldn't ruin investor appetite for U.S. debt because it would give the U.S. Federal Reserve less reason to scale down its stimulus program. Recall last month when Wall Street was almost certain the central bank would slow down its $85 million a month bond buying program only to surprise markets when it didn't. Fed Chief Ben Bernanke cited several reasons, including doubts Washington could get its act together and avoid a government shutdown. As it turns out, Bernanke was right, and he may turn out to be the unassuming hero.

Since the government partially shut down Tuesday, yields on the 10-year note have fallen to a seven-week low to 2.61%.

More than that, the market will likely interpret a default as temporary if Congress is slower to raise the borrowing limit. Investors would take it as symptomatic of political gridlock rather than anything financially wrong with the country, says David Ader, head of U.S. government-bond strategy at CRT Investment Banking. In August, he forecast the 10-year note would fall to 1.15% by year-end.

"It's about politics, it's not that the money isn't there."

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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