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TheStreet Open House

Republican Budget Brinkmanship Leads to Inverted Treasury Yield Curve

NEW YORK ( TheStreet) -- Treasury Bills issued by the U.S. government due in November carry a lower implied yield than those due at the end of October, as a government shutdown and possible default on the Treasury's obligations begin to panic short-term debt markets

On Tuesday, the Treasury sold $30 billion in one-month bills at a rate of 0.35%, a yield not seen since the depths of the financial crisis in 2008. The rate roughly doubled from Monday levels and means that U.S. government debt due in November carries a lower yield than debts due at the end of October.

In other words, the yield curve on Treasury Bills has inverted.

A scenario where some would rather lend money for a longer time and at a lower yield than debts due in late October, when the Treasury is projected to reach the legal federal debt limit, signals that wrangling over the government's finances is causing a sharp shift in investor behavior.

Weak demand for the Treasury's auction of one-month bills also could signal growing fear of a default.

" You can buy a T-bill that matures in October for a lower price than you can buy a T-bill that is due in November. Since these are zero coupon instruments that is just strange," Peter Tchir, head of TFMarket Advisors, wrote in a Tuesday client note.

"Another indicator of stress: Treasury yields are now inverted at short maturities," Donald Marron, Director of Economic Policy Initiatives at the Urban Institute and a former member of the President's Council of Economic Advisers, wrote on Twitter.

Inverted yields in short-term debt markets often signal wider issues throughout credit markets.

At certain points in 2007, short term interbank rates surged above those for longer terms. For instance, in August of 2007 the rate for one-month LIBOR exceeded the three-month, six-month and 12-month LIBOR rates.

In retrospect, we now know that inverted short-term LIBOR rates were a clear sign of a rising perception of counterparty risk throughout the financial system and a shortage of liquidity as investment banks tried to fund dollar-denominated mortgage securitization vehicles that previously had been off of their balance sheets.

The Federal Reserve and European Central Bank were forced into action that August; however, inverted short-term LIBOR rates persisted through March of 2008 when Bear Stearns was rescued by JPMorgan and a Fed backstop.

A yield surge on the newest issue of one-month and three-month government debt on Tuesday isn't likely related to any cash crunch, however, concerns about U.S. credibility appear to be taking hold.

Some buyers of U.S. government debt have stepped to the sidelines for the moment, likely as a result of fear that Congress may not be able to resolve a Republican-led impasse over the debt ceiling. If the U.S. were to default on debt payments, subsequent debt auctions would likely have even worse results and carry higher yields.

Bids during Tuesday's auction totaled $82.5 billion versus a prior six-month average of $162.6 billion for $40 billion in Treasury notes. Those auctions carried an average yield of 0.034%, according to Bloomberg data. Tuesday's auction also had the lowest bid-to-cover ratio since March of 2009.

For the moment, an inverted T-Bill curve indicates that buyers -- often foreign Central Banks -- are losing confidence in the the U.S. government as a creditor. Still, normal yields across the longer-term bond market reflect relative calm.

David Schawel, a fixed income portfolio manager and columnist for the CFA Institute's blog said on Twitter inverted short term Treasury rates indicate a real lack of foreign direct investment in the U.S., raising wider monetary and fiscal implications.

Even with Tuesday's rising yields, U.S. T-Bills still trade near par value. "Can you believe that we are talking about things that trade at 99.9% of par as showing signs of stress?," Tchir of TFMarket Advisors wrote in his Tuesday afternoon note.

-- Written by Antoine Gara in New York

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