Most economists agree that treasuries, specifically the 10-year bill, act as a strong barometer for investor sentiment about the economy. The price and yield of treasuries are inversely related, with a lower price leading to a higher yield (for example, paying $90 to receive $100 in the future represents a higher yield than paying $95 to receive that same $100). Additionally, increased demand will drive up the price of the bill. Therefore, low yields are the result of high demand.
Investors traditionally view treasuries as a very safe security, believing the United States will never default on its debt. Conversely, stocks carry much greater risk, as their prices are often more volatile and they are unsecured (i.e. payment is not guaranteed or required). When the economy started to turn sour in 2008, stocks plummeted. The result? Investors reduced their exposure to equities and gobbled up treasuries, sending rates plummeting. This was good news for the federal government. Why? Their cost of borrowing has fallen tremendously. Investors are willing to pay a lot more now to receive that $1000 in the future than they used to be, when stocks offered better returns. This presents what economists call a moral hazard. When the economy is doing well, treasuries are less appealing, and the government has to pay more to borrow (the other side of the coin is that, theoretically, when the economy is doing better, tax revenue is greater and welfare expenditures are less). Thus, during tough economic times, demand for treasuries increases, driving the price (i.e. the amount the government receives) up.
Similar to the housing crisis and home prices, this system rests on one simple notion: the government’s ability to repay its debt. A few weeks ago Moody’s cut its outlook on U.S. government debt, an extremely bold move. What this means, in essence, is that analysts who are paid hundreds of thousands of dollars a year to develop and use the most advanced economic models forecast that the U.S. government could default on its debt. Will the U.S. government be able to pay off its debt? The quick answer is yes, but to the tune of double-digit inflation. In the short run, however, what matters more, as is often the case in economics, is investor perception. Whether or not the government actually will be able to pay off its debt is irrelevant. If investors and analysts start to have their doubts, demand for treasuries will plummet, sending yields skyrocketing (similar to what is happening in Greece). Those yields are the rate that the government pays to borrow money. The result is that the government will have to pay exuberant rates to borrow very small amounts of money, further exacerbating its problems. Thus, even if the debt ceiling does not impede the ability of the U.S. government to borrow, Ben Bernanke and co. are not out of the woods yet.