August 6, 2011

Rate Impact of S&P Downgrade

August 6, 2011

Rate Impact of S&P Downgrade

There are two statements I would offer about S&P’s downgrade of U.S. debt:

1) S&P’s reasoning about the inability of politicians to address the real issue of fiscal sustainability is 100% correct.

2) the short-term effect on Treasury yields of S&P’s decision will be small.

The political problem stems from the fact that there is no inducement for politicians to be fiscally responsible.  Fiscal responsibility is not a path to reelection.

In the short term, the reason I don’t see yields (rates) moving as a result of S&P is they said nothing new.  There is no Treasury holder who knows something today that they didn’t know yesterday.  Moreover there are no good alternatives.  If you sell Treasuries what you have is U.S. dollars and what are you going to do with those.  The Eurozone debt issue makes all sovereign Europen debt less desirable that U.S. Treasuries.  Japan is fiscally worse off than anyone because of the enormous debt/GDP ratio and the fact that Japan has such a low birth rate that its GDP will fall with the population.

In short, there may be every reason to doubt that the U.S. has no sustainable fiscal policy but the fact is that U.S. Treasury debt is the best of the worst.

The technical indicators for U.S. Treasury debt show that yesterday almost completely satisfied the needed correction to the bullish rally.

We have vey high implied volatility in Treasuries and hopefully that will calm.  We should see Treasuries rally so that the 10-year yield is close to 2.1%.  If this rally does not happen, then the opposite will happen with a vengeance.

There is a lot going on.  The GDP report of a week ago showed the U.S. economy in a dismal state and that caused equity selling and Treasury buying.

Stranger yet,  Rick Davis of Consumer Metrics Institute says “On August 3, 2011 our Daily Growth Index went into growth territory for the first time in 566 days — ending the longest consecutive string of contraction-days that we have ever experienced. Furthermore, the rise off of the record lows set as recently as May 30, 2011 has been nothing short of spectacular.”

The fact is that the only entity who can lead the U.S. to recovery is the consumer and this leading indicator is now showing the consumer starting to act which is exactly what we need for GDP growth.