It has been a turbulent couple of weeks in the financial markets. Stock markets have been crashing globally, and in the middle of all of this; the US lost its AAA rating from the S&P. The loss of the AAA rating was a significant event, the first time in US history this has occurred.
The market reaction to the downgrade is confusing. Stock markets opened sharply lower following the downgrade. However, it is difficult to tell the extent to which this was due to the downgrade, as markets had been selling off prior to this. It's probably safe to assume that the downgrade has contributed to the market selloff, but is not the only cause of it.
Unlike the stock market, the reaction by the bond market is much clearer. And the bond market is telling us that US government debt is as safe as ever. Over the last two weeks, through the downgrade and the stock market crash, 10 year US government bond yields fell from 2.8% to 2.2%. Bond yields across all maturities fell; a clear indication that demand for US government debt remains strong.
What the bond market is telling us is that US government debt remains a safe haven in times of trouble, and that it remains an essentially riskless investment. Thus, investors do not believe that the US has become more risky following the downgrade. Of course this could change in the future as opinions change, but for now no one thinks a default will occur.
So why is there such a disconnect between what the S&P thinks of US government debt, versus what investors think? The S&P's rationale for the downgrade was that the fiscal position is getting worse, and the political process is ineffective to deal with the debt.
Both those points are correct, but the S&P is missing a crucial element of the US financial situation. The US has an independent central bank that can print money at will to buy government bonds. If the US is unable to solve its fiscal problems via reduced spending, they can always inflate their way out of the debt.
The most likely outcome of the US debt issue is that the debt will be inflated away over time. If inflation runs at over 5% while bonds yield less than 3%, the debt will paid off in time. For this reason, the US is very unlikely to default, even if their fiscal situation is poor, and even if economic conditions are poor.
The S&P rating appears to have missed this crucial point. This is why investors are continuing to buy US government debt despite the downgrade. No one really believes that default will occur.
This is not the only situation whereby the market disagrees with the rating agency. Japan has a debt level at around 200% of GDP, and has an S&P rating of AA-, and the economy that has been slumping for some time. Any guess as to Japan's 10-year bond yield? It's around 1%, one of the lowest in the world.
Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!