On Friday after market close, Standard & Poor's downgraded U.S. Government long-term debt from AAA to AA+. The USA won't suddenly fall apart because a rating agency downgraded its debt. Also, this can't be too big a surprise to bond experts – the USA clearly had incredibly high deficits, and growth of national debt accelerated back in 2005.
One of the immediate consequences, however, is that trillions of dollars of U.S. agency debt has suddenly been downgraded. Derivatives linked to government and agency debt will also be affected. This could shake up the derivatives market pretty badly, though I doubt the effects will be immediately visible.
Automated systems (program trading, algorithms, etc) are a big part of the modern financial system, including credit markets. U.S. Treasury debt and related derivatives are a very important part of these systems, and my concern is: how will the models respond to this ratings change?
Nobody knows the answer to this, because it's never happened before. Treasury debt was always assumed to be AAA.
My best guess as to “what will happen” is that instability will rise. Europe is already very weak, and flight to safety might chase money back to U.S. Treasury debt, despite the downgrade. Then again, all the credit market models in the world may start acting up, and something funny is sure to happen in the hyper-leveraged derivatives market.
It all adds up to instability, I think. If last week was any sign, volatility is increasing. Remember that volatility means that large swings up and down can happen (so bonds could rally).
An unstable system doesn't go straight up or down. It does weird and unpredictable things.
My Bull Index increased through July, then became bearish again at the start of August. Currently we are in a weak market and the indices are well below their 200 day moving averages.
My positions are unchanged since the last post in June.
- Perpetual Bull, firstname.lastname@example.org