The S&P Downgrade, One Crazy Year Later

August 01, 2012

On Aug. 5, 2011, financial markets as we know them were supposed to have ended. They didn’t then, but when will they?


The market closed on that first Friday in August and people went home for the weekend. Then, while some were asleep, Standard & Poor’s dropped the bomb on the market: The U.S. had been downgraded and lost its risk-free “AAA” status.

Fear, panic and calls for the end of the bond bubble ensued.

How high would the yield on the 10-year Treasury note go? How would the U.S. fund its deficits at astronomical rates? Would anybody be willing to buy Treasurys at historically low interest rates?

As we all now know, that moment proved to be one of the greatest contrarian indicators of all time.

Treasurys of all maturities began rising the following Monday. They didn’t stop climbing, and really haven’t stopped yet.

The iShares Barclays 20+ Year Treasury Bond Fund (NYSEArca: TLT), the long-dated Treasury portfolio, has returned more than 30 percent since that fateful Friday.

The Schwab Intermediate-Term U.S. Treasury ETF (NYSEArca: SCHR), Schwab’s intermediate Treasury portfolio, is up over 6 percent.

Of course, the performance of the short end of the curve has been relatively muted, but what do you expect when those securities are yielding next to nothing?

A Giant Among Midgets?

It’s the longer end of the curve where prices were most at risk from a reaction to the downgrade.

After all, these longer-duration bonds are by nature more sensitive to changes in interest rates and therefore had the farthest to fall. But the opposite happened: Prices rose, and substantially.

Of course none of this happened in a vacuum, either.

The European debt crisis gathered momentum in the beginning of the year, and took the euro, sovereign ratings in the eurozone and the ratings of European banks down with it.

The dollar and the “safest” dollar—denominated assets, U.S. Treasurys—were the logical alternative.

A Whiff Of Distrust

This was the springboard for bond prices, but it seems there was also something else at work: The market’s distrust of the ratings agencies.

After all, it was these same ratings agencies whose blind “AAA” ratings of mortgage-related collateralized debt obligations was a huge factor that helped trigger the loss of trillions of dollars in the fall of 2008.

It seems to me the U.S. downgrade failed to stir fear in financial markets because of the market’s distrust of rating agencies like S&P.

After their pay-for-rating business model was revealed and their conflicts of interest documented, it really is no surprise that the market met what was supposed to be a historic event with a collective yawn.

Sure, it made for great fodder on Fox News and MSNBC, but in the market, it proved to be a nonevent.



DC Snubs S&P

Perhaps more interestingly, it seems the policymakers in Washington have woken up to the same reality.

How else can you explain what they did this week by thumbing their noses at the ratings agencies with another kick-the-can-down-the-road-style budgetary stopgap measure?

If you recall, some of the main concerns in the S&P downgrade were political fragmentation and the inability to resolve the “debt ceiling” debate.

In “agreeing” on a six-month plan, Congress effectively said to S&P: “Thanks for your opinion, but we kindly disagree.”

And who can blame them?

The all-knowing market refused to punish the U.S. for its profligacy, instead choosing to reward it with lower borrowing rates. With that type of validation, I’m surprised politicians in Washington, D.C. didn’t pass a two-year stopgap measure that kicks the can all the way off the highway embankment.

None of this is to say that the market’s reaction to the downgrade makes sense.

To be sure, the U.S. is still struggling economically, its structural problems remain and the two candidates applying for the job of running the country are content to quibble over tax returns and social issues.

In that way, the downgrade seems to have emboldened Treasury holders as well as elected officials. If that’s really the case, then those calling for a bursting of the bond bubble may have to wait at least another six months.

Then again, if the downgrade itself was a contrarian indicator for those willing to buy Treasurys, maybe this time the complacency on the part of the bond vigilantes and Congress is the opposite.

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