The S&P Downgrade
by Charles Lemos, Tue Apr 19, 2011 at 01:27:46 PM EDT
Yesterday, the credit rating agency Standard & Poor's put US debt on a credit watch by lowering its outlook for US securities. In essence, Standard & Poor's is warning US policy makers and global investors that the United States risks losing its AAA credit rating unless policy makers agree on a plan by 2013 to reduce budget deficits and the national debt.
“If an agreement is not reached and meaningful implementation does not begin by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns,” New York-based S&P said today in a report that maintained its top rating on U.S. long-term debt while lowering the outlook to “negative” for the first time.
University of California economist Brad Delong writes in the FinancialTimes:
A spokesperson for Standard & Poor’s said on Monday that there was an “at least a one-in-three likelihood” that the rating agency “could lower” its long-term view on the US within two years. US equities quickly dropped by more than 1.5 per cent. Importantly, however, the dollar did not weaken and US Treasury interest rates did not rise. The reason for this unexpected pattern is simple: the markets think this move is important not because it signals something fundamental about the economy, but because of the political impact it will have in Washington.
So what is going on? A sovereign-debt downgrade is supposed to mean that a government’s finances have become shakier. This means that 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.
But if this were true the value of the dollar should have fallen on Monday. At the same time nominal interest rates on US debt should also have risen. The value of equities, meanwhile, could have gone either way: macroeconomic chaos would diminish future profits, but stocks have always been and remain a hedge against inflation.
But that is not what happened here. Instead equities fell, the dollar rose and nominal Treasury interest rates were unchanged. Given this, there are two things to bear in mind. First, you can go insane trying to over-interpret short-term market movements. Second, news comes in flavours: new news, old news, no news and political news. And it is important to understand which type this was.
If S&P’s announcement were genuine “new news” to the market, we would have expected to see the standard pattern: equities down, dollar down, rates up.
Meanwhile, if the announcement were old news, we would have expected to see no price movements at all – the smart money would already have taken up their positions. Equally, if it were 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. But this did not happen: we did see price movements, both in equities, and in the dollar.
Instead what we saw just what might have been expected to see if S&P’s announcement is seen 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.
I think DeLong is right. While Standard & Poor's said there’s a one-in-three chance that the rating might be cut within two years, the credit agency also noted its “baseline assumption” is that Congress and the Obama Administration will come to terms on a plan to reduce record deficits. And Standard & Poor's is playing its card hoping that such an agreement is more on the GOP side of the proposal. But this isn't new news.
Here is Clive Crook on the matter in The Atlantic:
"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."
What is new in Washington is that you have a large contingent in one political party of a rightist persuasion to begin with who thinks that a work of fiction by a third tiered Russian exile is an economic treatise.