Treasury prices are rising across the board (except for maturities six months or less) suggesting that the S&P downgrade is having little or no effect on the markets. What is affecting the markets is the overall economic outlook which is bad and getting worse. Now it may be that the sense that economic policy in the US is out of control, which, at least in part, was the basis for the downgrade, is affecting contributing to pessimism about the future, but in that case the downgrade is merely reflecting what the market already was sensing. But it is not quality of US Treasuries that is the issue.
From today’s New York Times story:
The decision late Friday by the ratings agency Standard & Poor’s to downgrade the United States’s debt rating one level to AA+ from AAA has global implications, said Alessandro Giansanti, a credit market strategist at ING in Amsterdam.
“We can see that this may force the U.S. to move more aggressively to cut spending,” he said, something that could drive the already weak economy into recession and weigh on the economies of all of its trading partners. “That’s the main driver” of the stock market declines, he said.
So the markets are taking fright because they are expecting more draconian cuts in government spending and perhaps increased taxes as part of an upcoming budget deal. You don’t have to be a Keynesian to understand that slashing government spending and raising taxes precisely when the economy is starting to weaken is not good counter-cyclical policy. But that is the program that almost everyone in Washington, gripped by a deficit-cutting frenzy, has signed on to. The idea that we must — MUST — reduce the budget deficit is now wreaking havoc. With the Fed apparently as paralyzed now as it was in September 2008, we are not in a good place.