Dynamics and Economic Analysis

Hands up everyone who thought that the S&P downgrade of the US would raise the Federal government’s borrowing costs. A funny thing happened on the way from theory to reality – the markets aren’t cooperating (excerpt):

Treasury yields plunge as stock markets swoon

WASHINGTON: Fears about the weakness in the U.S. economy and Europe's financial crisis caused Treasury prices to rally on Tuesday, sending long-term interest rates lower. Traders dumped stocks in search of lower-risk investments.

The yield on the 10-year Treasury note traded below 2 percent, near the lowest point on record, as strong demand for U.S. government debt boosted Treasury prices...

...Treasurys were plenty attractive on Tuesday as global stock markets fell. The Dow Jones industrial average lost as many as 307 points in morning trading, but recouped much of those losses and closed down 100 points. European markets had plunged on Monday, sending the Stoxx 600 index 4.1 percent lower. U.S. markets were closed Monday for the Labor Day holiday...

...The yield on the 10-year note was 1.97 percent at 4:30 p.m. EST, compared with 2 percent late Friday. Its price rose 12.5 cents for every $100 invested.

The yield fell as low as 1.91 percent late Monday, the lowest yield on record since the Federal Reserve Bank of St. Louis began keeping daily records in 1962.

All things being equal, a ratings downgrade would indicate a higher risk of default, and push investors to require a higher return to compensate for the additional risk they are taking on. Yet in the aftermath of the downgrade, yields on US government bonds have plunged to historical lows – more or less what I thought would happen.

So, what’s going on? Is economic and financial theory incorrect? Or are there extenuating circumstances?

The problem here is that generally in theory, you isolate the variables you are interested in to examine the impact of changes in other variables – hence the overuse of the infamous Latin phrase ceteris paribus.

But the real world is a lot messier than that, as all things are not equal nor can individual parts be held static for our convenience. The world is a dynamic system, not a lab experiment. Robert Lucas changed the face of macroeconomics forever by pointing this out – everything affects everything else and your models or theoretical framework better take that into account.

So here’s what I think is happening – long term borrowing costs possibly rose in the US relative to what it would have been before, but any such effect was swamped by the simultaneous increase in the global risk premium (either that, or the markets are assigning zero credibility to S&P’s ratings). The same factors that called into question the ability of the US to pay its debts, are the same ones that substantially increased demand for safe assets, for which the only real extensive supply (relative to global liquidity) is US Treasuries. So theory isn’t wrong – you just have to apply more than one of them at once i.e. all things cannot be held equal in the real world.

Hence, the paradox we’re confronted with today – the worse the the economy and the government debt situation in the US, the more likely yields on US Treasuries will remain low (and incidentally we should also have a lower spread between the long end and the short end of the market i.e. a flatter yield curve). And a resumption of growth and financial health in the US will result in higher yields demanded from TBills, especially longer dated securities, despite the concurrent improvement in US debt credibility.

Makes your head spin doesn’t it?