A warning from Standard & Poor's that mounting debts put the U.S. government's credit rating at risk blindsided markets last Monday. The Dow Jones industrial average lost more than 240 points in the morning before recovering. It was the worst one-day drop for stocks since fears over a nuclear meltdown in Japan sent investors into hiding on March 16.
The response made sense. A downgrade of U.S. debt, after all, could turn into an economic calamity. Here's the surprising part: After a quick dip, prices for U.S. government debt began rising.
Economists and bond traders offer varying explanations for the Treasury market's curious reaction, but there's a common thread: S&P's warning shot could actually wind up making bonds more attractive.
If an actual downgrade were to occur, the effects would ripple through financial markets. When S&P lowers the credit rating on a country, it's saying that there's a greater chance the country won't pay its debts. Creditors demand higher borrowing rates. In the U.S. it would mean higher interest payments for the federal government. All borrowers _ from companies, homeowners to credit card users _ would find it harder to borrow. Presumably, bond prices would fall.
The strength of Treasurys, the very debt that S&P said was at risk, left many observers confused. Aren't U.S. government bonds more dangerous now?
"There's quite a bit of head-scratching going on," said Guy LeBas, the chief fixed income strategist at Janney Montgomery Scott. "It looks like the bond market got hit in the head with a frying pan and is already up looking for a fight."
One reason that traders say Treasurys have looked surprisingly stable is the belief that S&P's move could spur action in Washington to tackle the country's debt.
In recent weeks, Paul Ryan, the Republican chairman of the House Budget Committee, and President Barack Obama had outlined plans to shrink budget deficits. Even if they were far from sharing common ground, the proposals generated a sense of progress, says Nick Kalivas, vice president of financial research at MF Global. "There was a sense that we're going to get something done," he says. "The move by S&P reinforced that."
Kalivas and others say the threat of a downgrade may push Congressional Republicans and the Obama administration to reach an agreement on tackling the country's long-term debts. Cutting spending and raising taxes would lead the government to sell fewer Treasurys. A drop in supply would likely push Treasury prices up.
The warning could also prod Washington to make even deeper spending cuts more quickly than they would otherwise. Economists warn that slashing too deeply, just like raising taxes too high, could threaten the economic recovery. That could actually help the bond market, too.
When the economy slows, investors tend to take fewer risks and favor stable investments like bonds. During the financial crisis, for instance, Treasurys trounced other investments.
In a note sent to clients last week, Goldman Sachs economists said the greater threat of a downgrade wouldn't translate into higher long-term interest rates and lower Treasury prices. In fact, it would have the opposite effect. "A significant push toward fiscal austerity would lead to lower growth," they wrote.
The Federal Reserve would also likely postpone raising short-term interest rates, because the threat of inflation would diminish. That, too, would add to the appeal of Treasurys.
In other words, what's bad for the economy is often good for Treasury bonds.
So how to explain the Treasury market's immediate reaction after S&P's announcement came out Monday morning? Treasurys dropped, causing the yield on the benchmark 10-year Treasury note to jump to 3.47 percent from 3.37 percent within 15 minutes. In the bond market, that's a giant leap.
Traders say there was initial confusion as they digested the news. Some panicked-sounding investors called trading desks asking how far the U.S. rating had fallen, mistakenly thinking the country had lost its AAA credit rating.
Many people glimpsed at the headline and saw the words S&P, U.S. and negative and assumed it was much worse than it was, says David Ader, head of government bond strategy at CRT Capital.
S&P lowered its outlook on the United States to "negative" from "stable." That's never happened before, but it's not a downgrade. And it's not even the step before a downgrade -- "negative watch."
S&P kept its highest AAA rating on U.S. government debt and said there was a one-in-three chance it would lower the rating in two years.
"Is this a downgrade, is this even a negative watch?" Ader asks rhetorically. "No, this is a negative outlook."
An actual downgrade would likely cause markets to react in the same pattern as they did after the S&P news. Stocks would fall sharply and Treasury prices would weaken, but only slightly.
LeBas' study of previous rating changes on countries over the past 10 years showed stock markets took the brunt of the hit. In the three months after downgrades, Spain's market dropped 8 percent in 2009, and Japan's market lost 3.4 percent in 2011. Janney estimates that a U.S. downgrade would cause the S&P 500 index to fall 6.3 percent in three months.
It can seem counterintuitive that stocks would fare far worse than bonds in the event of a credit downgrade. Here's why it happens: When the credit rating of a whole country is lowered, it means investors view every business in that country as more risky, which is bad for stocks. And if you're trying to avoid risk, where do you put your money?
You guessed it, government bonds.