Could this be the week when global investors start to get seriously worried about the looming August 2 deadline for raising the US debt ceiling?

Until now, global bond markets have operated on the sanguine assumption that a last-minute deal between the Obama administration and congressional Republicans will be reached, and that the world’s biggest economy, and largest debtor, will be able to avoid a catastrophic default on its debt.

Indeed, long-term bond yields have been dropping sharply in recent weeks as investors have focused on the fragile US economy, and the waning inflationary pressures. On Friday, the yield on 10-year bonds fell to 2.91%, its lowest level this year. Markets even shrugged off the warning from ratings agencies that the US government’s triple-A rating was in jeopardy unless more progress was made on raising the debt ceiling.

But Washington is doing little to justify the market’s confidence, with Democrats and Republicans continuing to bicker over the weekend. Republicans have signalled that they intend to put their “cap, cut and balance” plan to the vote this week, along with a provision to lift the debt ceiling. The Republican plan aims to cut the spending by $2.4 trillion over 10 years, cap government spending to 18% of GDP (down from its current 24%) and amend the Constitution to require a balanced budget.

But although this proposal is likely to pass the House, it is likely to encounter stiff opposition in the Senate. US President Barack Obama and Democratic law makers have argued that adopting an 18% cap on spending in a country with an ageing population and rising healthcare costs would mean brutal spending cuts.

On Friday, Obama urged US congressional leaders to “avert Armageddon” as the deadline approaches for a US budget deal. But time is quickly running out. The US government has already reached its $US14.3 trillion debt limit, but after its ultimate deadline, in a little over a fortnight, the US will have exhausted all the different ways to juggle its bills.

If the debt ceiling is not raised by that date, the country could begin to miss payments, including to bondholders and those receiving social security benefits. Last week, the ratings agency Standard & Poor’s warned that the US triple-A rating could be cut if the negotiations over the debt ceiling drag on for much longer, or if Washington fails to come up with a credible plan to reduce the US budget deficit by $4 trillion over the next 10 years.

Most market participants have shrugged off the threat of a downgrade of US debt, saying it is unlikely to roil global bond markets.

However, they warn that a failure to raise the US debt ceiling, which ultimately leads to the US defaulting on its debt, could spark a panic in global financial markets. US government bonds play a central role in financial markets, because they are considered the ultimate risk-free asset. If the US were to default on its debt, investors would sell off US bonds, pushing yields higher. This would have a ripple effect through the market, pushing up interest rates for all borrowers.

US government bonds are also widely used as security in money-market transactions. A downgrade of US government bonds would mean that borrowers would either have to pledge additional security or cut back the size of their borrowings. There are fears that a widespread deleveraging through the financial markets could again trigger a massive credit crunch in global financial markets.

*This article first appeared on Business Spectator