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What did the market think of S&P’s announcement?

By Ezra Klein,

Brendan McDermid Reuters Paul Krugman and Kevin Drum are discussing the curious drop in the bond market that followed the announcement by Standard & Poor’s that their outlook for the U.S. credit rating was negative (a drop that Business Insider piquantly named “the market’s middle finger to S&P”). “Actual bond traders not only ignored S&P,” writes Drum, “they decided that U.S. debt was even safer than they thought before.”

I think that’s such a weird response that we should be skeptical of it. It’s possible, as Brad DeLong suggests, that the bond market cheered the S&P’s move because traders thought it’d force the government to get more serious about the debt and thus made Treasuries an even better bet than they were Friday. But there’s another possibility, as well. One investor e-mailed to argue that the bond market wasn’t the story. The stock market, after all, tumbled upon S&P’s announcement. And he didn’t think this was so surprising:

Bond rates went down because investor worries about how fiscal crisis could hit company earnings went code red instantly. They sold corporate stocks and bonds and rolled the money into Treasuries.

Investors have been increasingly worried that Congressional gridlock and polarization will drive the U.S. into a fiscal crisis that will require sudden and aggressive spending cuts and tax increases to end it. When investors saw the S&P headline, they wondered how the companies they are invested in could be hurt if fiscal adjustments occur quickly. They asked, are the companies dependent on large government contracts? Are company customers dependent on unsustainably low income tax rates, tax loopholes or government subsidies? Eliminating fiscal shortfalls is good for companies long-term, but crisis-driven spending and tax changes will echo through the economy in millions of ways and hurt everyone.

In other words, a fiscal crisis that begins in the Treasury market could do more damage to entities that aren’t the U.S. government than it does to the U.S. government. This is pretty intuitive if you think about it. Washington will survive higher interest rates just fine. But plenty of smaller companies won’t. If there’s turmoil in the market, they’ll be unable to get credit. If we fall back into recession, they won’t make it through the year. The financial crisis was bad for the housing market and bad for the banks, but it was arguably worse on non-housing, non-bank firms that didn’t have the government standing behind them.

In some ways, I think the puzzle of the S&P announcement isn’t why the bond market didn’t go down, but why the stock market did. Nothing in that announcement was even mildly new. It was a banal statement that there is some chance that Republicans and Democrats won’t agree on a major package of fiscal reforms before 2014 and that if they go another three years without any serious action on the debt, the market will begin to worry. Was there anyone who didn’t know that Friday? How was that risk not already priced in?

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