Special Report 7.20.2011: Debt Limit Proposal

Recent low yields for Treasuries and MBS indicate that investors have priced in little risk of a damaging default when the debt ceiling limit is reached on August 2. For bond investors, the big question has been to what degree lawmakers would tackle the budget deficit. Simply lifting the debt ceiling without meaningfully addressing the deficit would disappoint investors and be bad for bonds. Tuesday, a bipartisan group of senators released a proposal to raise the debt ceiling which included a plan to cut the deficit by $3.7 trillion through a combination of spending cuts and tax reforms. President Obama backs the plan, and there is support from both Republicans and Democrats. The proposal marks a big step forward in reaching an agreement to raise the debt ceiling. Investors were pleased that the plan makes a serious attempt to bring the deficit under control rather than pushing the issue further into the future, and yields fell after the news. A smaller government deficit would mean a reduced supply of Treasury securities, resulting in lower yields. Less government spending also would slow economic growth, reducing inflationary pressures and making bonds more appealing. The plan still has a long way to go and likely will require many changes to attract the support needed to pass, but it’s a major step in breaking the deadlock and convincing the two parties to compromise.