Updated from 1:05 p.m. EDT
Update: "Even a short suspension of payments on principal or interest on the Treasury's debt obligations could cause severe disruptions in financial markets and the payments system," Bernanke said in a speech prepared for an event sponsored by the Committee for a Responsible Federal Budget.
Earlier: Later today, Fed Chairman Ben Bernanke and top Congressional leaders will be on hand for a conference entitled: The Debt Ceiling, Fiscal Plans, and Market Jitters: Where Do We Go From Here?
Where do we go from here? At this point, nobody really knows.
Depending you who you ask, a failure to raise the debt ceiling by the Aug. 2 deadline could bring about economic catastrophe…or be no big deal. (See: "No Downside" to Not Raising the Debt Ceiling, Says Chris Whalen)
Given the huge range of outcomes, and the political uncertainty underlying them, some banks are taking precautions by "preparing to cut their use of U.S. Treasuries in August," The FT reports. "One strategy…is to have more cash on hand to put up as collateral against derivatives and other transactions, decreasing the financial system's reliance on Treasuries."
The U.S. Treasury market is the world's deepest and most liquid, precisely why it's used as a substitute for cash in many financial transactions. Should the financial system become less reliant on Treasuries, the decreased demand would likely result in lower prices and higher yields, making it tougher on U.S. borrowers -- both public and private. Plus, many of those same banks the FT says are thinking about decreasing their use of Treasuries are also big holders of U.S. debt, meaning they could be shooting themselves in the foot if they really pursue this strategy.
The good news here is that prior to Tuesday, Treasury yields have been falling steadily -- even as the debt ceiling deadline approaches. As Dan Gross and I discuss in the accompanying video, that means the market is really worried (yet) about Aug. 2…or is flying blindly toward disaster.
One other thought: Increased demand for cash as collateral could put upward pressure on the dollar, which tends to be deflationary in the current environment…which tends to be good for Treasuries.