We’ve been talking about the stock market this week, so why not end it with a bold prediction: Once the federal debt ceiling is raised, look for the stock market to utterly tank within two weeks, certainly within a month.

While there are many reasons why the market is taking at least a pause if not slouching towards a correction, the most important is the appetite for government debt. A time like this requires careful management and attention to consequences. We’re not getting it. What we have instead is mismanagement on an epic scale that will certainly spook the market and ultimately kill it.

The presses are rollin’

The issue at hand is the cost of money. Popular mythology says that it is all a matter of the Federal Reserve setting rates, which is partially true. The cost of money to banks in the Fed system is determined by the Fed Funds Rate, which is in turn set by a board called the Open Market Committee. They use a complex formula to guide them, something which can be estimated.

What actually determines the rates seen by companies and consumers alike is the going interest rate or yield on US government debt. The most popular benchmark is the 10 year treasury. It is influenced by the Fed Funds Rate, and usually runs at a premium to it. But there is a lot more to it than that, as the 10yr treasury yield is determined by the market.

Like everything in the market, it’s a matter of supply and demand. Higher supply than demand, and treasuries go down – which makes the net yield, a set number of dollars fixed at the time of the auction, go up.

Money talks, but bonds have a nationally syndicated show.

Right now, the 10yr yield is going up very rapidly, which is to say that bonds are falling. Demand for them has weakened as there are other places to put money all around the world where anyone can expect a higher return. While the demand is dropping, the supply is going up as the US government seeks to borrow more.

That’s the key here. How much is the US government borrowing?

On 7 Feb there was a routine auction of $24B in 10yr treasuries. The net yield from them was determined by what investors were willing to bid for these bonds. At the end of the process, the yield went up from 2.77% to 2.85%, which may not seem like a lot. But it was a signal, and the market suffered the next day.

The next auction of 10yr notes is on 8 March.  It is scheduled to only be $21B, but expect that to change.

Because of the debt ceiling, the Treasury Department is delaying all the payments that it can. These include deposits into pension funds, payment of contractors, and so on. The exact amount being delayed is unknown, but it’s certainly in the tens of billions. Once the debt ceiling is increased, a large wave of bonds will be sold at auction. It will be a wave on the order of $40B in 10yr treasuries, if not higher.  It will include the routine service on the nearly $14B in publicly held debt plus the amount currently held back since about November.

Yikes!

The main reason for the rising hunger for money by the federal government is the tax cut passed in December, which as we noted has added $400B to the annual debt. But the deal to increase the debt ceiling looks like it will add about $200B more to this year’s debt, and possibly even more. The need for financing, through auctions of treasuries, is only going to increase, and dramatically.

When it does things will go badly. They couldn’t even sell $24B in new debt without a substantial spike in the yield.

The key is when and how the 10yr yield crosses 3.0%. That may well come before any action by Congress, so the possibility of a stock meltdown ahead of time is real. But there are powerful forces (read: a lot of money) ready to support stocks as long as they can.  They will hold out an minimize the downside until they simply can’t.  That’s when all Hell breaks loose.

It is less about the level of the 10 yr yield than the rate of rise. When the debt ceiling is lifted, we can reasonably expect it to rise very rapidly – something on the order of 0.3% in less than a week. All of this is likely to happen without any action by the Federal Reserve, which is more likely to announce more rate hikes to the Fed Funds Rate than not, given inflation.

Bad stock news requires a picture like this. Apparently, these traders still exist.

So that leaves us with a very specific prediction: The debt ceiling will be raised and the back payments made as soon as possible. They will be financed with a wave of treasury sales, which will start with short-term debt as much as possible but will have to include longer-term debt to avoid inverting the yield curve (a technical sign that a recession is coming). If they really screw up, they’ll invert the yield curve, but more likely the 10yr yield will spike up to about 3.3% very quickly. That will legitimately spook the stock market and a huge drop. It may even rival 1987’s 22% drop in one day, but is more likely to be in the 10% range – a staggering 2,500 points on the DJIA.

You heard it here first.