U.S. Downgrade Hype: Bond Yields Are the Only Credit Rating That Matter

Includes: SBND, TBT
by: James A. Kostohryz

The news is out: S&P downgraded the sovereign debt of the U.S.

S&P’s Verdict:

“We have lowered our long-term sovereign credit rating on the United States to ‘AA+’ from ‘AAA’ and affirmed the ‘A-1’ short-term rating.

“The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.”

In the immediate aftermath of the downgrade, S&P admitted that it had made an embarrassing error in its calculations. This could conceivably cause the agency to revise the rating.
More likely the error will simply undermine the already compromised credibility of S&P and the rating agencies as a whole.
S&P Rating Is Functionally Irrelevant
The fact of the matter is that the only credit rating that matters is the yield that that is set in global bond markets.
Right now the historically low nominal and real yields on U.S. Treasury securities are signaling loud and clear that investors expect neither default nor significant inflation.
Negative nominal interest rates on short term T-Bills demonstrate that investors are so confident about the solvency of the U.S. Treasury that they are literally willing to pay money for the U.S. Treasury to safe keep their money.
Ten-year Treasury yields (^TNX) at 2.55% and 30-year yields (^TNY) at 3.82% similarly are signaling that investors have few concerns about the long-term solvency or creditworthiness of the U.S. government. And when we analyze real interest rates, which are currently negative all along the curve, it is clear that investors are not discounting any significant probability of default or inflation.
As I point out in my article “The Market’s Downside: S&P 500,” the U.S. and global economies face major challenges. Perhaps the most pressing, at the moment, is market volatility and the heightened risk aversion that this generates among investors, consumers and business managers. The S&P downgrade clearly does nothing to reassure markets.
However, in its downgrade, the S&P did not reveal anything that bond investors did not already know. Nor does the S&P have any privileged information. Furthermore, the S&P had been signaling this move for some time, so it should come as no great surprise to markets.
Thus, the downgrade will give pundits much to blow hot air about. But in the end, it is of no functional importance. And it is only of marginal importance psychologically in terms of setting the general mood. It is just one more ingredient in a complex stew.
Note that I am long SBND and TBT not due to fear of U.S. default but for reasons outlined in “The Market’s Downside: S&P 500” and "Market to Force Hand of Central Banks."
Disclosure: I am long SBND, TBT.