Dusting Off the Debt-Ceiling Playbook

The stock market has been responding to the on-again, off-again debt-ceiling negotiations in a predictable fashion. When things are looking up, as they did toward the end of last week, it rises. When they turn sour, like on Friday when Republican House and White House negotiators hit a sudden impasse, it stumbles. And this makes sense: A failure to reach a deal before the Treasury Department becomes unable to pay its bills could send financial markets into disarray and even plunge the economy into a recession.

The Treasury market, on the other hand, has been harder to figure out. Investors have been bidding up longer-term Treasurys in particular when the debt-ceiling negotiations look rocky, pushing yields lower. Insofar as they are a traditional safe-haven asset, that might make sense, but then again, wouldn’t Treasurys be at risk of default if the negotiations fall apart and there is a debt-ceiling breach?

The dynamic was similar in 2011. Back then, the debt-ceiling standoff went to the 11th hour when internecine fighting in the Republican-led House threw a wrench in negotiations in late July, yet long-term Treasury yields fell and kept falling even when, shortly after an agreement was reached, Standard & Poor’s downgraded its rating on U.S. debt.

In retrospect, that drop in Treasury yields was understandable. The economy was weak, and uncertainty surrounding the debt ceiling added an extra drag. Europe’s sovereign-debt crisis was worsening, increasing global demand for U.S. debt. And, unlike then, investors know that the Treasury Department had put together a plan to prioritize making payments on interest and principal, while delaying other payments, such as for veterans’ benefits, as necessary.

Moreover, as UBS credit strategists note, the safe-haven status of Treasurys isn’t so much a function of their being backed by the full faith and credit of the U.S. government but their status as the deepest, most liquid market in the world. When things get hairy, the ability to buy and sell many assets can get more difficult. Not Treasurys, though.

Oddly, a rating downgrade could even make Treasurys more attractive to certain funds. Many have an average credit-rating threshold for their holdings that they need to meet. If credit-rating firms downgraded U.S. debt as a result of a default, it would bring those average credit ratings down. But because Treasurys would probably still be higher rated than many of their other debt holdings, funds would have to sell some of that lower-rated debt and buy more Treasurys to stay above their rating threshold.

Whether Treasurys would really respond to an actual debt-ceiling breach as they did during the near breach in 2011 is unknowable. And even if yields did, in fact, slip, over the longer haul shaken confidence in America’s willingness to pay its obligations might well push yields higher. When in uncharted territory, investors have no other recourse than to try to make an educated guess. Continuing to buy Treasurys despite today’s uncertainty would appear to be it.

Write to Justin Lahart at Justin.Lahart@wsj.com