A Few Weeks Later: Did the Debt Downgrade Matter?

Well, we've had a bit more time to analyze the situation since the S&P downgrade of the U.S.'s credit rating.  Did it impact interest rates? Yes, but not how it was expected.

Ten year treasury rates have dropped off a cliff and are now well below the year on year change in CPI (3.6%).

Granted, this isn't the best measure of "real" interest rates, but it does give some sense of where we are now. This has actually gotten more extreme in August where we would be in near historic territory, except for the few blips in the 1970s where there were peculiar alignments of inflation rates and interest rates for brief periods.  It's clear that we have not seen any increase in real rates and don't seem to be near it either. 

Once again, all of the devastation has been in the equity markets.  As I said earlier this month, we would have a brief period of stabilization before a resumption of the fall.  We followed that traditional pattern and appear to be on another down leg.

At this point, it seems quite likely that we will see more difficult days ahead, but not because of a debt-induced panic.  Rather the issue is that growth prospects have utterly and decisively collapsed at this point.  The Philly Fed Index this last week was an utter disaster.  At over -30 (or under depending on how you look at it), it is at a level that has never failed to be associated with recession.  Once again, the threat is deflation and stagnation. 

When do the markets start taking the obvious insanity of politicians seriously?

It's been clear up to this point that the financial markets have not taken what is an ever clearer picture of the true insanity of members of Congress seriously. How do I know that the markets haven't taken it seriously? Because we are still standing far too close to one year highs. The fact that we have fundamentalists in Congress who believe that they must obtain a total victory or they'll take the whole country with them should be more disquieting to markets than it has been so far.

I fear that this may be like the TARP vote, which I will maintain to my dying day was necessary, where financial markets had to absolutely implode in order for financial markets to jar Congress out of its tizzy. However, the fundamental problem is that we may not have quite that window available to us. While it is entirely possible that the Treasury can find enough scraps of money around to keep debt service going for a little while if it puts off other key functions, the simple truth is that at some point there will simply not be enough cash on hand to make a particular interest or principal payment. If the Treasury has to pay $25 billion one day and only has $13 billion on hand, to quote a number of characters in a number of movies, "Well, shit". That would cause the requisite collapse in financial markets, but at that point it would be far too late.

As I've noted before in this entire debate, the U.S. has had its AAA credit rating for years for a number of reasons, but one of the most principal reasons is not only has the U.S. never defaulted before, but it has never even really come particularly close to defaulting (with one modest exception in the Panic of 1893) and our politicians have never really considered it a possibility that they would allow it to happen. I think that this bizarre charade alone warrants a loss of the AAA rating more than our current debt load does.

Is there a material problem from losing "AAA" status?

In short, the AAA status will be lost or not lost in the marketplace long before a credit rating agency actually decides to downgrade U.S. treasuries. Markets always are about two or three steps ahead of the rating agencies. Look no further than any of the recent sovereign debt crises or the 2007-2008 debacle with mortgage backed securities.

The one material effect is in the investment policies of pension funds and endowments where there are certain requirements as to the percentage of AAA assets that need to be held as a portion of the portfolio. If U.S. treasuries aren't considered AAA, it would be hard to imagine what would step into the void.

As far as the likelihood of a downgrade, that is hard to say. If Congress actually decides to grow up and face the long-term deficit problems like it has a spine, these are not insurmountable issues. A few modest tax increases and well balanced spending cuts would do the trick in a hurry. However, an unfortunately large number of representatives have decided to invoke moral absolutes, which should almost never be part of this process. As a result, we are not looking too good at the moment. Perhaps the S&P warning may have been enough to get people thinking a little more clearly.

A Brief Note on Financial Crises and Safe Harbors

One of the great new contrarian pieces of "knowledge" has been that you can hide from a developed market financial crisis in emerging markets. This was said in 2007 and 2008 when we went into the soup and it was said again this time during the ongoing European financial crisis. Just to show how silly that idea is, here is a chart from June 1, 2008 through March 1, 2009:

The green candlestick line is the S&P 500, the olive line is the FXI from yesterday, the purple line is the iShares MSCI Emerging Markets Index Fund (EEM) and the light blue line is the iShares Brazilian Index Fund (EWZ). As you can see, over this period, the U.S. outperformed all of those markets for the duration of the worst of the crisis.

Similarly, in the current crisis the pattern has been continued:

The pattern is repeated, to varying degrees. So, what is the safe harbor? U.S. Treasuries have been, are, and will likely continue to be the last best hope for investors in the midst of a crisis. I could show the chart from 2008, but that's just beating a dead horse. Here's the most recent performance with the iShares Barclay's 20+ Year Treasury Bond Fund (TLT) represented by the.... I guess that's salmon colored line:

As you can see, long-duration U.S. Treasuries are a good safe harbor for assets in short term financial crises, regardless of whether they are here in the U.S. or if they are in Greece, China, Japan, or wherever else there might be a crisis. That being said, as a long term prospect, I am not thrilled with the outlook for Treasuries at the moment as I have indicated previously. As interest rates rise in the future, you will get slaughtered for a large position in them. In the short run they might be appealing, though even here I'm not sure how much more upside they have. I think we are probably within a couple weeks of the worst of the European crisis being behind us, though it will get ugly before it is over.

Someone may ask "What about gold?". In response I say, "Treasuries > gold" in a crisis. It was true in 2008. It is true now. Gold is only superior in a time of hyperinflation.

Anyway, those are my thoughts.