Stocks Down, Bonds Down! No Flight to Safety?

Over the last year the US bond market has been the place to hide when the stock market swoons. With the US Federal Reserve pledging support for bond prices via quantitative easing it seemed logical to seek refuge in "safe" assets. However, today that relationship is breaking down, and it has traders asking why? The knee jerk answer is that inflation is once again on the front burner, especially since the Philadelphia Fed Index (released today) showed that prices paid by manufacturers had reached highs not seen since July 2008. To be sure, inflation has been moving higher recently, however there may be another explanation for the rise in interest rates and the fall in US stocks…the debt ceiling.

The United States places a self imposed limit on the amount of debt it is allowed to issue. The power to set this limit rests in the hands of the US Congress, which is akin to leaving the mouse in charge of guarding the cheese. Whenever the United States needs to issue more debt the Congress simply changes the rules and lifts the debt ceiling. In fact, since 1962 the debt ceiling has been lifted 66 times…that is an average of 1 ½ times every year! However, this time might be different, albeit slightly.

There is a giant game of chicken being played in Washington, DC that is having a big impact of the stock and bond markets. The United States will likely hit the current debt ceiling in March 2011, which has prompted Treasury Secretary Geithner to exclaim that "failure to raise the limit would precipitate a default by the United States." True enough, since the entire US government budget is based on the need for more and more debt, however, this is not a surprise. The US has been brushing up against the debt ceiling for quite some time. So why the big deal now?

The "big deal" is that the newly elected Congressional leadership is proposing a Constitutional Amendment which would require a balanced budget and this amendment will be tied to the passage of a debt ceiling increase. In other words, this will be the last time the debt ceiling will ever be lifted…assuming Congress doesn’t change the rules again (yes, I know a BIG assumption). A Constitutional Amendment requires a 2/3 majority to pass, while a singular vote on the debt ceiling would require only a simply majority. It is this dynamic that is rattling the bond market.

Believe it or not there are credit default swaps (CDS) on US government debt, I am not sure who will have any money left to settle the transaction if the US government ever did default, but that is a discussion for another day. As of yesterday’s close US government CDS prices have reached all time highs, suggesting the risk that the US will default on its debt has never been higher!

Due to the wonders of the electronic printing press it is virtually impossible for the United States to default, but the game of chicken being played in DC has resulted in higher interest rates. It is this game of chicken that has caused the bond market AND the stock market to go down at the same time. As the drama unfolds, I expect the interest rates to climb regardless of the direction of the stock market and it for this reason that I added to my long position in TBT today.

* Today’s Guest blog is written by Brian Kelly, Kanundrum Capital founder and CNBC Contributor

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John Melloy is the Executive Producer of Fast Money. Before joining CNBC, he was an editor for Bloomberg News, overseeing the U.S. Stock Market coverage team.