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. 

The Strangest Financial Crisis

So, when I looked at the early quotes on ten year treasuries on Friday afternoon, when word of the looming S&P downgrade began to surface, quotes suggested a rise in rates to about 2.55%-2.60%. I thought that was a fairly reasonable reaction since the loss of a grade might be worth a dozen or so basis points in higher yield.

What I did not expect was that rates would plunge today to the lowest levels since the worst of the 2008 panic. This is why I call it the strangest financial crisis. Under most, or all, circumstances the fears surrounding a country's sovereign debt cause the two following reactions:

1. Interest rates spike like mad
2. The currency collapses
3. The equity markets collapse

Well, one of those happened. The other two did not. Hell, the dollar actually rose slightly: http://www.bloomberg.com/apps/quote?ticker=UUP:US

Normally, when people are told there is a bomb in the building, they run out of it for the refuge of other structures. That did not hold today, not one bit. Instead, what seems to have happened is that the markets fear the consequences for economic growth more than they do the downgrade itself. Normally, the channels affecting economic growth would be a spike in real interest rates and a collapse in the integrity of financial markets. In this case, the concern appears to be that our current rate of economic growth is as good as it's going to get because the downgrade has precluded any possibility of stimulative action by the government. Further, the ripple effect of downgrades to private and municipal issuers is likely part of what is at work here as well.

It is also possible that markets are anticipating a major hit to consumer confidence as people pull in their horns in anticipation of future interest rate increases, which I will point out is not a rational behavior. Much like someone prone to panic attacks can induce one due to the fear of one coming on, the markets can collectively do the same thing. The fear of future consumer... fear probably motivated some of the indiscriminate selling today, and it was indiscriminate.

A further mechanical cause is the incredible plunge in oil. It's down almost 20% in a few weeks. This has caused mass liquidations by hedge funds, who have to liquidate virtually everything, including shares in damn good names. I am struck by a plunge like this in United Technologies (UTX), one of the best run companies in the world with a tremendous track record of strong earnings growth and healthy dividends:

Hell, even a company like Church and Dwight (CHD), which is basically immune to recessions and will benefit from the plunge in petroleum prices, has taken a clipping:

The banks got slaughtered, which is understandable. If indeed U.S. interest rates are heading higher, banks' margins will get squeezed. Fair enough. Also, Bank of America (BAC) is one sick puppy these days. Seeing a collapse of this magnitude in a premier financial stock is not reassuring:

Still, the basic theme to take away is simple. The market has rapidly priced in a significant reduction in economic growth prospects and the related effect on earnings growth. This is not principally a U.S. debt crisis and should not be labeled as such. If it were, money would not have sought out U.S. treasuries in such massive quantities today. We are faced with a market that is rapidly pricing in deflation due to a weak economy, which explains the dual decline in stock prices and bond yields. Concerns about inflation are radically misplaced at this time. All of the inflation of the past several months has been driven by food and energy. Those are dead now. Their declines will be seen in CPI over the next few months and year over year inflation will vanish.

At this point, continue to hold cash for the moment. A bounce back, possible a big one (+500 pts or so) or two will happen in the next week or so, but that will probably be greeted with a fresh low sometime thereafter. These things never go straight down then straight up. Even 1998 with LTCM, which is the closest to that trajectory, did not follow that pattern. Stabilization was followed by new lows before a solid bottom was formed. The opportunity will come, but it isn't here quite yet.