The following analysis offered by Steve Jones, associate professor of finance at the Kelley School of Business Indianapolis, provides answers to some of the questions generated by the recent stock market volatility.
The roller-coaster ride of the stock market following the brief downgrade of the U.S. credit rating showcases the tenuous nature of investors today. The combination of recession fears, politics, and historical errors may have some investors unsure the safest path to follow in future investing.
Here is a brief rundown of how this event transpired. The Dow Jones Industrial Average fell by about 5 percent, or 600 points, over the ten contentious days leading up to President Obama’s signing of the bill to raise the U.S. Treasury’s debt ceiling on Tuesday, Aug. 2. After relatively little response the following day, the Dow tumbled an alarming 500 points on Aug. 4. By the next evening, after world financial markets had closed for the weekend, Standard & Poor’s downgraded U.S. Treasury debt from its long-time AAA rating, saying the budget deal did not go far enough. On Aug. 8, the Dow fell over 600 points, in an apparent response to the downgrade, but then made up over 400 of this on Tuesday, only to give that 400 and 100 more back on Wednesday. The rest of the week saw a recovery of 800 points, back to pre-downgrade levels.
So what is happening here?
Conventional wisdom in the broadcast media is that these wild swings are all about the U.S. debt crisis and the S&P downgrade. But in terms of economic fundamentals, the downgrade means very little. The other two major security ratings companies, Fitch and Moody’s, both responded to S&P’s downgrade by reaffirming their AAA ratings on U.S. Treasury debt. And investors responded by driving yields down, and thus prices up, on the benchmark 10-year U.S. Treasury. In fact, the 10-year U.S. Treasury is now yielding almost one-half percent less than the Euro-denominated debt of the French government, which S&P still rates as AAA. How can this be? Why are many large institutional investors willing to pay more for what S&P says is the more risky U.S. debt? Basically, they are reaffirming a collective belief, as did Fitch and Moody’s, that U.S. Treasury debt is still the world’s safest investment. And why now are many institutional investors fleeing for the safety of U.S. Treasuries?
The real underlying fundamentals that have driven the financial markets since mid-July reflect a combination of the European debt crisis and renewed fears of a double-dip recession in the U.S. This has led many large institutional investors to seek a safe harbor where they can sit out the next few months until the uncertainties surrounding these situations become more tolerable. The negotiations over raising the U.S. Treasury’s debt ceiling were a secondary actor in this until S&P decided to be the proverbial tail that wags the dog by downgrading U.S. debt. The result was a week of unusually high volatility as many less-disciplined investors reacted to the downgrade by running for the exits, only to see more disciplined investors take advantage later in the week.
The real issue now is why did S&P downgrade U.S. debt when large institutional investors along with Fitch and Moody’s so clearly disagree? Some have suggested politics, but more likely, it reflects S&P’s lingering embarrassment, from several years back, over having rated mortgage-backed debt too high for too long, and thus, contributing in part to the financial crisis of 2008. In which case, S&P apparently believes it is better to be overly cautious and downgrade now. Better to be first and maybe even wrong, eventually, then to be late again, apparently. We see a similar mentality now prevailing in banking and real estate markets, where collateral is being undervalued and, thus, hampering economic recovery just as overly easy credit led us into crisis. Fortunately, the U.S. Treasury’s cost of and access to debt is ultimately determined by investors in the world financial markets and not by bureaucrats.