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 Cole said...

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

Benjamin Cole 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!

MCKibbinUSA 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.