On Friday, Standard & Poor’s, one of the three main credit rating agencies, downgraded U.S. Treasury debt from AAA to AA+, citing doubts about the effectiveness, stability, and predictability of American policymaking and political institutions in being able to deal with the rising debt burden by the middle of the decade. It’s been a wild ride for equity and commodity markets ever since.
Somewhat incredibly, Standard & Poor’s made a $2 trillion error in their calculation of future U.S. deficits. The other two major credit rating agencies, Moody’s and Fitch reaffirmed that they will be maintaining their AAA ratings. And Paul Krugman is among those questioning how an agency that had given AAA ratings to trillions of dollars of questionable mortgage-backed securities could now decide that U.S. debt had become more risky.
Still, the fundamental unease that many of us have been feeling about the U.S.’s long-term fiscal challenges could only have increased watching events in Washington over the last few weeks. I would have hoped that both parties could agree that, whatever differences we may have, the country is willing to bear whatever burdens are necessary to honor existing debt commitments. The erosion of that hope is part of what gives the decision by S&P some personal sting.
If this were all to be taken at face-value– if a rational, objective observer now sees less certainty of timely payment of interest and principal on U.S. Treasury obligations– the response should have been an increase in yields on Treasuries relative to other, supposedly safer obligations. But, as Krugman also notes, we observed exactly the opposite. The yield on 10-year Treasuries fell 18 basis points on Monday to 2.40%, and is down 61 basis points from July 27. Investors are buying 30-year Treasuries yielding 3.68%, down from 3.82% on Friday and 4.29% on July 27. S&P may be concerned about prospects for U.S. default, but the market seems not to be.
Notwithstanding, the dramatic plunge in equity and commodity prices seems likely to have been related to the downgrade. Tim Duy suggests some reasons:
Should the downgrade have significant economic consequences? I fear the answer is yes. First, if you believe confidence is important, that confidence has surely been shaken, as evidenced by wild ride of financial markets. Second, the political response could be a full-court press for more fiscal austerity. Finally, we don’t completely know the knock-off effects on the rest of the financial system.
Heightened uncertainty– and that’s what we have here– brings a flight to safety, ironically, to U.S. Treasuries, which can wreak havoc for everybody else.
Many observers also seemed to be hoping that these events might trigger a new round of large-scale asset purchases from the Federal Reserve. The direct effects we might hope for from these would be to depress long-term yields even further. It would of course be odd to claim that the main problem is that these yields haven’t fallen enough over the last two weeks. Instead, the concern must be whether inflation expectations are coming down again with deteriorating economic conditions. The break-even inflation rate (10-year nominal minus 10-year TIPS) fell from 2.45% July 27 to 2.20% on Monday. There is room for the Fed to be reminding everyone they’re not going to tolerate deflation.
Instead of more large-scale asset purchases, the FOMC settled instead on replacing its previous boilerplate commitment to maintain an exceptionally low federal funds rate “for an extended period” with a new, more concrete statement that rates will remain exceptionally low “at least through mid-2013”. And this change in wording was approved over the objections of 3 of the current 10 voting members of the FOMC. If we do see more deflationary pressures developing, I would expect the Fed to embark on QE3, but until that happens, this may be all we’re going to get.
While the U.S. debt downgrade is one of the dramatic events that began this week, I continue to stress that other developments are more critical. Although the security of U.S. sovereign debt is not really yet in question, the same is not true of peripheral Europe. With the spread of those concerns to the major economies of Spain and Italy, we have reached a very troubling situation there. The worry is that banks may suffer significant losses on some European sovereign debt. Fears about that may freeze lending more broadly, for a possible replay of the disastrous events of the fall of 2008.
Even in the absence of those developments, there is no question that the U.S. economy has been weakening considerably. JP Morgan reminds us that U.S. stock prices declined 15% or more within the space of 4 months on 30 separate occasions since 1939, and only half of those were associated with an economic recession.
But watching this morning’s stock market, it’s hard to be confident that this time is going to turn out in the favorable half of the distribution.