Risk Free Rate No Longer Risk Free
In theoretical finance, the rate on Treasury bills and bonds is considered the risk free bench mark rate. For example if I were to loan you $500, for three months, to make my risk worthwhile, the rate of interest you would have to pay me should be more than the T-bill rate to compensate me for the risk I am taking. The basis for this assumption is that no matter what happens the Treasury will make good on its debt, its default risk is zero. The antics of the Republican Congressional leadership are calling into question this very premise. A US debt default will send shock waves through the global financial markets. The crash of 2008-09 will look like small potatoes in comparison. The notional value* of interest rate and currency derivatives is around $560 Trillion, while the notional value of credit derivatives at the heart of the global financial collapse of 2008-09 was about $50 Trillion. These derivatives are traded between banks and are the so-called OTC or over the counter derivatives, whose details are only known to the participants of the contract. This time the Treasury and Fed will have a lot less room to maneuver. This will certainly affect interest rates and the value of the dollar.
GOP office holders meanwhile are making statements that downplay the consequences of default. This is what Tom Coburn said,
I’d rather have a managed catastrophe now which I don’t think will be there, I’m not saying we shouldn’t pay our bills. What I’m saying is we should put ourselves in a position where we have to start making hard choices now.
But what else can we expect from a party that is allergic to science and impervious to facts, trapped in their own bubble made of Kevlar?
ETA: Meanwhile, Fidelity the largest manager of money market funds is unloading short-term US debt.
ETA2: *Definition of notional value of a derivative from Wikipedia: The notional amount (or notional principal amount or notional value) on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument. This amount generally does not change hands and is thus referred to as