[ronigafni]

This may be too hypothetical to get a clear picture on, but I was wondering what the world would look like in a month from now if the U.S.’s credit got a major downgrade tomorrow and interest rates shot up dramatically. Would that lead to bank insolvencies? Would it cause increased prices from a devaluation of the dollar or decreased prices from lack of spending? What would happen to the bond market? etc…

[jmherbener]

If U.S. Treasuries were downgraded, then interest rates would rise, or be higher than otherwise, on U.S. Treasuries. Because the rise of rates on Treasuries would be compensation for the greater risk of holding Treasuries, it would not necessarily lead to arbitraging into other bonds and higher rates for them. There were no wide-spread ill effects on bond markets from the Standard and Poor’s downgrade of Treasuries from AAA to AA+ in August 2011.

For banks that held Treasuries, if the downgrade raised their rates it would evaporate bank equity. Whether or not it made them insolvent would depend on the extent of their Treasuries holdings and equity. Even if it made banks insolvent, the Fed would probably intervene to keep them in operation.

I don’t see that it would have an effect on the dollar, unless investors thought that the federal government would rely more heavily on monetary inflation in the future to finance its expenditures.

[ronigafni]

Well at the point in time that interest rates on treasuries went up it seems the cost to pay the interest would become so enormous that there would be no choice but default or inflate. I heard that 5 trillion of the debt rolls over every year because it has become short term. If that is the case wouldn’t the new higher rates almost certainly lead to immediate inflation?
Also, about the bond market. When you say “it would not necessarily lead to arbitraging into other bonds and higher rates for them. ” What would determine whether it would have a ripple effect or not?

[jmherbener]

At the end of 2012, the Federal debt is $16.4 trillion, but the debt held by the public was $11.5 trillion. The Interest paid on treasuries held by the Fed go to the expenses of the Fed and any surplus is remitted back to the Treasury.

The interest paid on the federal debt in 2012 was $220 billion. Federal expenditures in 2012 were $3.6 trillion. So interest made up 6 percent of the Federal budget. Interest rates could double or even triple without initiating a nightmare scenario on the Federal budget.

Arbitrage does not eliminate the difference in interest rates between high-yield securities and AAA. So if Treasuries are further downgraded and command higher interest rates to entice lenders to buy them, then there will be no arbitrage between the higher interest rate Treasuries and higher rated securities.

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