August 9, 2011

S&P Knocks U.S. Debt, Debt Buyers Knock Back

Pundits point to contradiction of rush to treasuries after treasuries are downgraded

Despite a historic downgrade of U.S. government debt on Friday, investors still judge it a safe harbor when weathering market turbulence, if Monday’s “flight to quality” is any indication.

“Fears that America would have to pay more to borrow on the world's financial markets after being stripped of its coveted AAA rating proved to be wide of the mark on Monday, as yields on U.S. treasury bonds fell,” wrote Guardian UK’s Larry Elliott on Monday in a view from abroad.

While this may prove to be a temporary phenomenon, Elliott noted there were “good reasons to think that bond yields will remain low and could even fall further.”

“In one sense, a decline in U.S. bond yields is counterintuitive,” he wrote. “The debt downgrade by S&P was supposed to warn investors that the U.S. is now a riskier place to put their money. Investors, in turn, should demand higher interest rates for holding US assets.”

So what’s happening? Three explanations were proffered.

“The first is that despite the downgrade, U.S. assets are still considered safe,” according to Elliott. “There is only a marginal difference between America's old AAA rating and its new AA+ rating; the real impact at this stage is psychological and political.

The second reason, he wrote, bond yields may be falling is in part due to travails in the euro zone. In times of trouble investors looks for safe havens in the “Big Three: gold, Swiss francs and U.S. bonds.

“However, it is the third explanation that looks most compelling, namely that movements in U.S. bond yields reflect what investors think about the underlying health of the American economy,” Elliott concluded. “Bond yields tend to go up when economies are growing rapidly and financial markets catch a whiff of inflation. Bond yields tend to fall when growth is weak and they fall a lot when there is a perceived threat of deflation.”

In other words, he says, economic fundamentals have more influence on the bond markets than the credit rating agencies. As proof, he offered Japan’s recent economic history.

“[Japan] lost its AAA rating a decade ago and has national debt of 225% of GDP, yet Japanese 10-year bond yields are 1%. The real measure of Japan's stagnation has been the stock market not the bond market, with the Nikkei trading at just over 9000 points—a quarter of its level at the peak of the boom. Similarly, the true barometer of the health of the U.S. economy over the coming weeks and months will be the S&P 500, not the 10-year bond yield.”

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