Therefore, the case to hold long-term U.S. Treasuries amid a debt ceiling crisis is compelling. However, it's essential to consider the followings:
Today, the conditions for a large U.S. Treasury rally might not exist.
Looking at the graph above, from the beginning of July 2011 until August 10th, 10-year U.S. Treasury yields dropped by more than 100bps. Yet most of the drop (70bps) occurred after an agreement was reached to increase the debt ceiling on July 31st. Why? Because (1) markets were reassured that the U.S. would be able to pay its bills, (2) a selloff in stock markets was triggered by the largest one-day national debt increase in history together with agreed spending cuts, and (3) S&P’s downgraded the U.S. long term credit rating, increasing safe havens appeal. Thus, in July 2011, amid the debt ceiling debacle, 10-year yields dropped by 35 bps only. Subsequent events caused the most significant gains.
This consideration leads us to one big question: can the same also happen this time? Maybe, but it depends on the stock market. With a debt ratio of 136%, the U.S. is already one of the most indebted countries in the world. Rating agencies might proceed to downgrade the country’s rating further; however, if there are no substantial spending cuts, it might be challenging to see a 4% drop in NASDAQ or S&P. Let’s not forget that the stock market is on steroids and that a drop in long-term U.S. Treasury yields (regardless of the cause) can be seen as positive for tech stocks. Therefore, there is a significant probability that long-term U.S. Treasuries will gain, but probably less than we witnessed in 2011.
The devil is duration.
Compared to T-Bill, long-dated U.S. Treasuries carry a much higher duration risk. If yields rise, you will lose much more value on your investment than short-dated bonds.
Ten-year US Treasuries yields are trading in the lower part of the range they have been trading since March. That means that if inflation remains sticky and the economy continues to show bags of resiliency, there might be better scope for 10-year yields to soar rather than drop. Considering that 10-year Treasuries now offer 3.47%, yields could test the upper range at around 3.7% if yields break above the short-term falling trend line. The loss an investor would suffer is approximately 2 cents on the dollar.
Yet, if yields break below their 3.28% support driven by a gloomier economic outlook, they might find support next at 3%, potentially bringing a gain of 4 cents on the dollar.