Monday, August 8, 2011

The unintended consequences of the Treasury downgrade

Last month I had a post on the likely consequences of a Treasury downgrade, and it now looks prescient. Those who are unfamiliar with the law of unintended consequences might have thought that a Treasury downgrade would make Treasuries less attractive, driving up their yield. Now we know that just the opposite has happened: Treasury yields have plunged in the wake of the downgrade. But there's more to the story, since the plunge in Treasury yields has been accompanied by a surge in the yields of junk bonds. The explanation for why this has happened is in the post referenced above. The short answer is that a Treasury downgrade has reduced the average quality of the world's bond portfolios, and many of those portfolios are being forced to sell their low-quality bonds and buy more Treasuries in order to bring their average quality back up to where they want it.

7 comments:

Benjamin said...

Five year Treasuries at 1 percent. This is inflation? Investors fear inflation?

Benjamin said...

NYMEX crude down to low $80s today. We will see both core and headline inflation go negative in next few months.

So be happy! We have beaten inflation.

William said...

Very prescient indeed!

Dr William J McKibbin said...
This comment has been removed by the author.
Jeff said...

And gold is at $1720.

The dollars in your pocket are loosing value Benjamin. And you think that's a good thing.

Charles said...

Perhaps the same factors driving up junk bond yields,ie portfolio adjustments to maintain a target risk profile, are driving down stocks.

TradingStrategyLetter - Weekly Summary said...

THe bond market is NOT going to escape this. I suspect it is still being supported by Washington - who have been the only real buyers this year and are loaded with their own IOU's! All a result of nothing more than decades of financial economic engineering and masterminding! If you want to see real fear and distruction just wait until it goes limit down for a few weeks. Interest rates will easily triple. They will be lucky to hold a single 'A' rating. Such a same to see. I get sick thinking about it.