At Columbia last year I took a class called “Modern Political Economy” from Ray Horton. One of Horton’s favorite things to say was that sooner or later, if the U.S. didn’t solve its debt issues through the political process, the world’s capitalists would do it for us — as in the debt markets would punish us for our profligate ways, and raise the cost of borrowing.
(Hemera)
And yet, here we are: a ratings agency has downgraded our credit for the first time ever. But on the first day of trading, rather than going up, rates on our government debt fell to near record lows as money poured out of riskier assets in a flight for safety. When the markets closed last Friday, and the U.S. still had a AAA rating from S&P, the yield on the 10-year Treasury was 2.55%. It ended Monday down to 2.34%. The same thing happened during the stock market sell-off in the fall of 2008, when the rate on the 10-year Treasury went from around 4% to less than 2.5%. U.S. government debt is still the safest, most liquid market in the world. The S&P downgrade doesn’t change that. In fact, the immediate effect has been to make it safer. How strange.
Also worth noting, as Nate Silver pointed out on Twitter Monday afternoon, is that prices on U.S. credit default swaps barely budged on Monday, up just .3%. A credit default swap is essentially an insurance contract to protect against a company or a nation defaulting on its debt. If the market truly believed S&P’s downgrade was deserved, prices for CDS contracts on U.S. debt would have gone up significantly yesterday.
Finally, a quote in a Reuters story from a credit analyst caught my eye:
“The CDS market has been pricing the U.S. credit as an AA credit for some time,” said Otis Casey, director of credit research at Markit in New York.
U.S. CDS had traded below 2 basis points until late 2007, when concerns about the need for government spending to bail out financial institutions began. Fears over the rising debt burdens of governments have increased since this time.
“There is not a concept anymore of a risk-free rate,” Casey added.
I find this silly. U.S. T-bonds and bills have been a proxy for the risk-free rate for decades. Without a risk-free rate, modern finance essentially falls apart, since it is the building block of most financial models. People use it for determining everything from the value of a company, to the price of an option or a bond.
Of course, the very concept of a risk-free rate has always been relative. It assumes a zero chance of default. If you want to get technical, there isn’t a zero chance of anything really. But still, as the market proved on Monday, U.S. treasuries are still the least risky place to put your money in the whole world. So there you go: AA is the new AAA. Proceed.
and 
. You can also watch it on 
For emerging markets, after a period of short-term volatility, it will be business as usual. China will complain loudly as the downgrade bolsters its case for more stringent debt management in the United States. These complaints will lack teeth, as China will need to maintain and add to its US Treasury portfolio to protect the asset from painful devaluation. A large sale of US government debt by China would be far more impactful to markets than the revised credit rating from S&P.
Other emerging markets stand to gain from this decision. They will lobby the ratings agencies for higher credit ratings based on improved debt management processes and lower debt ratios. The ratings agencies will have to react in favor of the emerging markets issuers, or risk losing their own credibility. In the years to come, the decision to downgrade the US (and possibly France, Germany, UK, Australia and other debt-laden markets) will benefit emerging markets as higher ratings will result in lower interest rates and more liquidity for them. Having access to capital markets on these terms will be one of the most important steps in graduating emerging markets to emerged markets.
http://blog.frontierstrategygroup.com/2011/08/impact-of-us-debt-downgrade-on-emerging-markets/
All we need to do is like the good-old Eisenhower days when tax on income could go as high as 90% or more.
If you took all the income from all the people making over $250,000 a year, you would not make a dent in our budget problem…and the next year you would get nothing from this tax because no one would work here.
There was a difference between 2008 and today. In 2008, gold went down.
«In fact, the immediate effect has been to make it safer. »
You confuse the concept of price (interest rate) with risk. Sure, the interest rate is an amazingly accurate proxy for risk, but it is also subject to the laws of supply and demand.
In this instance (as you yourself observed), a fall in interest rates does not mean investors consider T-Bills safer. It means demand for T-Bills went up.
It is telling the you chose to ignore T-Bills with maturities of less than 10 years.
“I too would like to see an actual, real world example of the number problem that fooled the best and brightest on Wall Street.”
Sure, see anything related to CDOs, syndicated lending, Trust Preferred Securities, Sub-Prime MBS. Wall Street both created and bought this junk. It fooled just about everyone, hence 2008. Ooh, don’t leave out auction rate bonds. Total garbage.
The S&P would have been smart to leave the US and other countries at AAA and simply create a new AAAA rating to reflect the increased riskiness of the world in general. Therefore there would have been no downgrade…just an upgrade for select super safe entities…if any actually exist.
“just an upgrade for select super safe entities…if any actually exist.”
Switzerland.
It is sad to see how the academic understanding strays so vastly from the real world. So let me try to enlighten.
Honestly, try to think of all the people you know of who, when they heard of the debt downgrade, went out and bought long and short term US paper. Come up with anyone? Of course not. The only people playing that game were traders and institutional players i.e. banks.
Now why would they do that? Because for traders it makes sense. Who would believe that bond prices would go up in such an environment. No one. And the trend has been up so you stick with the trend. That’s why the trade works. For banks, it works because they do have to do something with the cash from retail investors who are selling other assets. Maybe these people are even selling bonds. But guess what – the banks don’t care. They just want to make whatever extra money they can off people’s idle dollars for which they are paying jack squat as it sits in their savings account.
So they go out along the curve and find yield and then they find yield between the yields i.e. arb the curve from the 2′s to the 10′s to the 30′s. Whatever the models tell them to do.
Now for the CDS’s. So the CDS prices didn’t rise as much as one would expect under the circumstances. Shocker. Not really. Care to look at what CDS prices were doing weeks if not months before the downgrade? No? Well, they were going up. So guess what happens when someone who had the foresight to buy something cheaper gets the chance to sell something at a higher price? I’ll provide a hint: it has to do with investing and it has to do with trading. That’s right – they buy low and they sell high. Novel concept I know.
That’s how investing and trading work. You find something that no one thinks has any value. Buy it as cheaply as possible and sell it when people think there’s value there. Whether that is true or otherwise. Every dog has it’s day and every trader lives by that expression.
What are the odds of a US default? The author provides the answer and he probably doesn’t even know it. He says the US t-bill rate has been used as a proxy for a risk free rate even though technically that impossible because the default risk cannot be zero. Of course there is a zero chance. They have a printing press. You’d have to be pretty dense not to appreciate that fact and the fact is the market certainly appreciates that fact.
Those CDS’s are worthless. So why would there be a value on them at all? Let’s look at some other financial instruments. How about sub-prime MBS’s that are rated AAA? How about internet stocks with nothing but an address and no chance of ever generating revenue – except through stock sales? What about umpteen other things that ended up at their intrinsic value of zero?
Obviously, the retail gal/guy can’t be buying these CDS’s but who’s to say some dumb schmuck junior portfolio manager out there doesn’t fall for it. Or even the senior manager who knows that at some board meeting down the road some dumb schmuck director will ask if she’s “hedged” the sovereign exposure to the ol’ US of A and it’s easier to buy some and say yes than to explain the reality to someone who’s dumb enough to ask the question in the first place. Besides it just a cost of doing business and doesn’t really mean squat to her take home.
Should interest rates have gone up? Of course not. But why not. The real answer is because they can’t. If interest rates go up, everything falls apart. The problems become obvious and obviously bigger. And just like in 2006 and 2007 and 2008, when all of officialdom was saying “what smoke” as they ushered the VIP’s out the side door of the theatre, the problems won’t be obvious to the public until it’s too late. (How many folks woke up this week to find out their mutual funds have been losing money since early May? How many of your family or friends were talking about getting out of the market before this week?)
In the end, rising interest rates won’t be the tip off. It’ll be buried in something like option prices where the professionals will know that the next big blow up is around the corner and will be hurriedly selling fixed income products to unsuspecting retail folks at unbelievable, once in a lifetime prices.
On August 11, 2011 Frontier Strategy Group surveyed 52 senior executives on the effects of the S&P downgrade and slowdown in the U.S. and Eurozone on their businesses in emerging markets. Participants provided their predictions for what is to come in the midst of the current economic uncertainty.http://blog.frontierstrategygroup.com/2011/08/data-mnc-executive-response-to-economic-uncertainty/