Overinterpreting the S&P Treasury Rating Downgrade Threat

 |  Includes: DIA, SPY
by: Brad DeLong

James Fallows asks a question:

Today's (Needless) Hysteria: the S&P Panic

I agree with Clive Crook's puzzlement about the S&P downgrade "bombshell" today:

S&P adduces no new information that I can see. Competent ratings of opaque instruments such as, oh, mortgage-backed securities would be very useful to investors (not that ratings agencies troubled to provide competent ratings in that case, obviously). But why should anybody need that kind of help in judging the soundness of US government bonds? S&P knows nothing about them that you or I don't know ....

I know that markets run on fear, greed, instinct, and panic as much as on logic. But seriously, how could this non-story have dominated the news today?...

  1. To repeat Clive Crook's point, S&P knows nothing more about U.S. budget prospects than you or I do. They're saying they have an opinion on the state of Congressional-White house dealings on the budget. Fine. Go on a talk show or start a blog.

  2. To repeat James Galbraith's different but also true point: As long as the U.S. government doesn't tie itself up in debt-ceiling insanity, it is not going to default on dollar-based bonds. It can't. It controls the "means of production" for the dollars to pay off those bonds. If you're worried about inflation, fine. But that's a different matter, with a lot of other variables that count for more than S&P's feelings.

I think it may be more complicated than that. First, let's look at the S&P announcement:

“[W]e believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years,” Nikola Swann of Standard and Poor's said Monday morning. “The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012.”

"Could lower" is a weasel phrase: What is a "one-third chance we could lower our long-term rating"? Nevertheless, the announcement triggered a drop by U.S. equities of more than 1.5% after S&P's announcement. But the dollar did not weaken; it strengthened by nearly 1.0%. And U.S. Treasury interest rates did not rise.

What is going on here? A sovereign-debt downgrade is supposed to mean that a government's finances have become shakier: The likelihood of internal price inflation is higher, the future value of the nominal exchange rate is likely to be lower, and the possibility that creditors might not get their money back in the form and at the time they had contracted for had gone up. The value of the dollar should have fallen. The nominal interest rates on U.S. Treasury debt should have risen.

The value of equities could have gone either way; macroeconomic chaos would diminish future profits, but stocks have always been and remain a hedge against inflation. That is not what happened here: Equities fell, the dollar rose, nominal U.S. Treasury interest rates were unchanged.

There are I think, two things to bear in mind. First, you can go insane trying to overinterpret short-term market movements. Second, news comes in flavors: New news, old news, no news, and political news.

If S&P's announcement was new news being conveyed to the market, we would have expected to see the standard pattern that we did not: Dollar down, Treasury nominal interest rates up, equities either way. So it is not new news.

If the announcement was old news, we would have expected to see no price movements: The smart money would already have taken up its positions, and when those less-informed investors to whom S&P was news responded by selling, the smart money was there to buy and offset. That's not what we saw either -- so it is not old news.

If it was no news -- if the market as a whole simply thought that S&P was irrelevant -- then we would have expected to see no price movements at all. The problem is that we did see price movements, both in equities and in the dollar. So it is not no news.

That leaves us with political news. What would we have expected to see if we were to read S&P's announcement not as a piece of information produced by a financial analyst studying the situation, but instead as a move by a political actor trying to nudge a government toward its preferred policies? What asset price movements would we have expected to see then?

If we are willing to run the risk of possibly overinterpreting short-term market movements, we see that confidence in the U.S. and the dollar as a safe haven strengthened: Some people who were previously leery of keeping their money in dollars out of fear of future depreciation are now less leery. We would have to judge that markets expect the S&P announcement to be successful, considered as a political intervention: Ms. Market thinks the S&P has just increased the chance of a long-term budget deal.

But what about equities? How can investors bid down the prices of equities if they are more confident that the U.S. will resolve the future fiscal problems created by both parties' appetite to extend the Bush shift of the tax burden from the present into the future, and by the explosive growth of government-funded medical care costs?

There are two natural hypotheses. The first is that Ms. Market expects future stockholders to bear a large share of the burden of restoring long-term fiscal balance. Perhaps Ms. Market is thinking back to the Bradley-Baker tax reform of 1986: Cut marginal rates on individuals but increase the tax base, reduce tax expenditures, and raise corporate taxes and thus the burden on shareholders.

The second natural hypothesis is that Ms. Market views the S&P move as a political intervention that will lead to more restrictive and austere fiscal policies in the short run -- and hence to a slower recovery and an enhanced risk of renewed recession. Ms. Market is thus pricing that extra risk into today's equities.

And, as Felix Salmon points out, maybe Ms. Market does not care about S&P. Maybe Ms. Market is worried about Europe, and fears renewed global recession from the spread of the European financial crisis.

My guess (which might well be wrong) is that we saw the price pattern that we did because Ms. Market views the S&P announcement as a political move. Congress, she may be thinking, is like a mule: It only moves when hit with a whip. Normally the whip to get a deficit-reduction deal is fear of the bond market's producing a spike in interest rates and borrowing costs, but perhaps a fear of a ratings downgrade will do instead.

And my next guess (which also might well be wrong) is that the dominant view of Ms. Market is that this will harm equity holders not so much by loading more of the burden of balancing the budget on corporate and capital gains taxes, but rather by slowing recovery and raising the risk of a double dip.

Over the next few months, we will see if Ms. Market is right.