Why Grandma Yellen Must Be Forced To Prioritize Spending

Let’s first reprise the great 2011 debt ceiling showdown. On July 28, just a few days prior to when the Treasury’s borrowing authority would have been exhausted, the yield on the benchmark 10-year UST note stood at 2.98%. And despite months of heated warnings to the freshly elected GOP House majority about its duty to promptly pass a “clean” debt ceiling increase that figure was actually down considerably from the 3.36% yield of early January 2011.

That’s right. As shown below, the whole seven month ordeal on Capitol Hill about the expiring borrowing authority resulted in, well, an irregular but marked decline of the benchmark bond yield.

Yield On 10-Year UST, January 2011 to August 2012

On July 31st the House GOP famously capitulated, agreeing to a big debt ceiling increase in return for what was advertised to be $2.1 trillion of deficit reductions over the next decade. At that point the yield dropped further to 2.58% on August 5th, the day S&P dramatically cut the UST credit rating from AAA to AA+ after the market closed.

The folks at S&P were apparently not amused by the banana republic “brinkmanship” that had prevailed on Capitol Hill for the better part of the year. So they sternly admonished Washington that—

The downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenge,” the company said in a statement.

Did the yield soar the next week in response to America’s loss of its purported pristine credit rating, as had been warned ad nauseam by the Wall Street and Washington powers that be in the run-up to the crisis?

Why, no, it did not. By year-end 2011 the yield had further fallen to 1.89% and, as shown above, by the first anniversary of the downgrade in early August 2012 it had plummeted to just 1.50%.

Moreover, by the latter point the Y/Y inflation rate was running at 2.0% on our trusty 16% trimmed mean CPI. In effect, one-year after all the debt ceiling strum and drang of 2011 the real yield on the benchmark government security was negative 50 basis points. That is to say, the US government lost its pristine credit rating and was rewarded with tens of billions of annual debt service savings!

It might be argued, of course, that the $2.1 trillion deficit reduction plan which accompanied the GOP debt ceiling capitulation is what caused yields to go down, not up. But that doesn’t wash, either.