But Didn’t S&P Downgrade US Bonds…

by robekulick

The Dow fell 630 points today and to the average well-informed person this makes sense given that S&P downgraded the US’ long-term debt. But luckily there are economists in the world to make even this seemingly obvious truth more complicated.

S&P downgraded the US’ debt, that is it bonds. When bonds are downgraded, their prices generally fall and their yields rise because there is supposed to be a higher probability of default. But what happened today is that US bond prices rose and yields fell! See: http://online.wsj.com/mdc/public/page/mdc_bonds.html.

In fact as the economist Scott Sumner pointed out today in a post, (http://www.themoneyillusion.com/) this is effectively the market telling S&P that their ratings are meaningless. Viewed from this perspective, it is possible then that today’s large stock sell-off has nothing to do with what S&P did and simply is further reaction to the continuing slew of bad economic news that seems to be piling on.

But, a 630 point movement in the Dow is a fairly unusual event so even I can’t shake the feeling that some of this is reaction to the downgrade this weekend. If that is true, there are two possibilities.

First it is possible that the sell-off today was irrational and that since the S&P ratings mean nothing for the stock market, the decline will abate as rational traders begin to buy again.

However, another possibility is that although the S&P downgrade does not effect stocks directly, institutional factors create a link between the two events. For instance, some institutional investors like pension funds have rules where the only debt they can hold is AAA. Of course, one would think this would trigger the selling of bonds causing their prices to fall not rise, but it is still possible that, for instance, selling will effect leveraged positions at banks and cause more contraction in the credit markets.  Or it is possible that the market thinks the loss of the US’ triple AAA ratings will cause cataclysm among bond insurers. And finally, since I am not an expert on the nitty-gritty of our bond markets, it is highly likely there are a number of other institutional factors that could be causing the link between the downgrade and today’s turmoil that I simply don’t know about or understand. Either way, I think we can safely say that if anything it seems like the full faith and credit of the US is starting to mean more and more to investors.