The stock market wasn't very pleased with the news that Standard and Poor's downgraded U.S. debt from AAA to AA+ on Friday. The major indices were down between 5% and 7% at market close on Monday. But another market wasn't particularly concerned with the downgrade on U.S. debt: the market for U.S. debt.
Below you'll find three Treasury yield curves. The first (red) is from April 15, 2011, the day before S&P first voiced its dissatisfaction with politics surrounding U.S. debt by putting the U.S. rating on Negative Watch. The second (purple) is from Friday, August 5, 2011, the last market reading prior to downgrade. The third (green) is from market close today, Monday, August 8, 2011.
Notice a trend here? The louder S&P complains, the lower the yield on Treasuries. This is the opposite of what you might expect to see. The lower a yield, the higher the demand for a bond. Put another way, as S&P became more and more critical of U.S. Treasuries, investors were willing to pay more and more money for them.
If S&P's critiques meant much to bond investors, then we'd be seeing the opposite result: Treasury yields would be rising since April. Clearly, investors must not be particularly concerned with U.S. debt's risk profile. As you can see, bonds have seen significant declines since April, particularly for longer maturities. For example, the yield of 10-year Treasury bonds has declined 103 basis points from April 15th to August 8th.
One explanation for why Treasury bonds are trading at such low yields could be investors' growing risk aversion to other investments. Since April, the U.S. economy has deteriorated, and few investments are thought to be safer than Treasuries. Clearly, however, S&P's downgrade did little to change that view.
Although there are some other very low-risk assets available for investors fleeing to safety, there aren't many good ones. One option is gold. It was up more than 4% on Monday, so some investors are putting their money in the precious metal. But others might be worried that its value has become overinflated over the past couple of years.
Investors looking to park their money in the AAA-rated sovereign debt of other nations may run into a supply problem. As my colleague Megan McArdle showed last week, U.S. debt accounts for around 60% of the AAA-rated sovereign debt market. In other words, the Treasury market is 50% bigger than all of the other AAA-rated sovereign debt markets combined. There just aren't enough of these other bonds to go around if many investors try to dump Treasuries.
But as the yield curve above shows, investors aren't dumping Treasuries. In fact, they're flocking to U.S. debt, despite the S&P downgrade. Rather than the demand plummeting on news of the rating agency's action, demand rose, pushing down yields even farther.