Fiscal crisis barometer: watch the spreads between corporate and Treasury bond yields.

• Author: Ahn, David

Given America's current and projected deficits, some Treasury officials wonder ,why Treasury bond yields are so low. We believe they are focusing on the wrong indicator. The first sign of fiscal crisis will be a widening of corporate-Treasury yield spreads in a process we call fiscal adjustment cost (FAC) discounting. Because of the United States' longstanding reserve currency position, the relationship between corporate and Treasury assets is crucial.

It is wrong though to think that government debt is just debt of a government. Government debt is debt of the government's constituent people and businesses. Government debt is a liability, and regardless of whether businesses think of it this way or not, some portion of it is an implicit liability on their balance sheets.

For markets, it is the unsustainable portion of the debt that matters. This is the portion that is going to be forcibly eliminated in a U.S. fiscal crisis by massive spending cuts and tax increases. Spending cuts and tax increases to achieve fiscal sustainability will echo through the U.S. economy in millions of ways. Done within a planned long-term framework, the results will be beneficial. If the needed fiscal adjustment is as large as the Congressional Budget Office and Government Accountability Office say it is, and if done suddenly and aggressively, every U.S. household and business will be hit, and the ones most dependent on unsustainable spending and tax policies will suffer most.

FAC discounting describes how investors move the unsustainable portion of a company's implicit government debt liability onto the company's balance sheet as probabilities of crisis-driven spending cuts and tax increases rise.

FAC liabilities are off-balance-sheet in stable times, but as the odds of a fiscal crisis rise, investors move these liabilities onto company balance sheets and reduce investments in those with the highest FAC liabilities. As crisis risks rise, investors sell corporate bonds and stocks, and force the yield spread between corporate and Treasury assets to widen. Some investors will move out of U.S. dollar assets altogether, pushing the dollar down. However, many need to keep portions of their assets in dollars because of currency allocation decisions. These investors will sell corporate securities and buy Treasury debt, pushing down Treasury rates relative to corporate rates.

A widening of the spread between corporate and Treasury yields will be the best indicator of...