Earlier this week, when Standard and Poor's revised its outlook on U.S. debt from "stable" to "negative," the stock market plummeted. Oddly, Treasuries did not. In fact, they rallied. This might seem strange. Shouldn't Treasury securities -- the very bonds that would be most adversely affected by negative rating action -- have taken a hit? It may seem like bond investors are simply ignoring political risk, but the market is complicated.
They Don't Believe It
The most obvious reason why most bond investors didn't blink after hearing S&P's action is that they don't believe there's any real chance that the U.S. would default. They're absolutely correct. The U.S. will not default, particularly not in the near- to medium-term. Even if the debt ceiling debate carries on for months, Treasury investors will be just fine. Congressional Republicans and Democrats may be involved in a game of fiscal chicken, but they aren't crazy enough to allow the nation to default.
They Don't Believe It -- Yet
Even if the U.S. doesn't default, if S&P goes further and decides to downgrade the nation's debt, it would have real consequences. Some global investors would dump Treasuries, as would some bond funds that only hold AAA-rated securities. A downgrade would be disastrous.
But S&P did not downgrade the debt, the firm simply voiced its concern, effectively scolding Congress. Because the rating agencies have been criticized for being too reactive, instead of proactive, S&P likely saw this as an opportunity to voice its annoyance at U.S. politicians ignoring the deficit. That's easy to do through a little outlook change; a downgrade is not so simple -- it would have very serious consequences. If that begins to look like a realistic possibility, then bond investors will begin to worry.
They Find the S&P's Negative Outlook Positive
In fact, bond investors might have found S&P's action refreshing. Ultimately, bond investors just want to make sure they continue to be paid. S&P's action puts grater pressure on U.S. politicians to stop the shenanigans and develop a long-term deficit reduction plan. Any action that encourages policymakers to get the nation's fiscal house in order should be cheered on by bondholders.
Then Why Did Stocks Fall?
What's good for bond investors isn't always good for equity investors, however. While cuts in government spending and higher taxes might better ensure timely payments of U.S. debt, it's also a recipe for slower U.S. growth. Whether you believe government spending effectively stimulates the economy or not, surely someone is getting this money using it. And if corporations or individuals are forced to pay more money to Uncle Sam to close deficits, then they'll have less left over to invest or spend to promote growth.
Moreover, the threat of a U.S. debt downgrade is a blemish for the nation that overseas investors might interpret with caution. They likely don't perform as rigorous analysis of U.S. fiscal policy as domestic investors, so foreign investors will be more reliant on the rating agencies' grades. S&P's action could serve as a confirmation of the decline of U.S. business, which would impact global demand of U.S. equities.
Political risk matters to all investors, but different types of investors can sometimes have different reactions to a new development. In the case of the S&P outlook change, no new information was revealed about the U.S.'s fiscal health. As a result, bondholders saw no reason to panic. But the government response to S&P's wrist-slap could result in slower growth and less foreign interest in U.S. stocks.
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