Why Treasury Yields went down when US was downgraded ?
This was a phenomenon which one hardly sees in his lifetime. When US was downgraded from triple A rating to AA+ by S&P on 8 Aug 2011, it was thought US Treasury yields would go up which would cause interest rates to go up. Well, if we go by the books, it should have happen. But, on the contrary, treasury yields dropped.
It wasn’t an irrational behavior on the part of investors.
A very simple reason for such an investment behavior was the fact that the US ratings are not just the depiction of US’ ability of pay back the interest on its borrowing but a measure of the health of entire financial system. Equities, Bonds, Currencies, T-Bills, G-Secs, etc. are all complexly linked with the performance of the US economy.
A downgrade of financially most robust and strongest economy meant an automatic downgrade of all the financial assets and instruments which can be extended to other countries too. This means everything could be seen as a downgrade. I call it ‘virtual downgrade’ as it all happened in the minds and perceptions of investors rather than the actual downgrades. Many assets which were lower in the hierarchy of ratings would have moved into range of junk investments and investors would have opted to sell those junks and buy safer assets. So, there was a general loss of confidence among the investors along entire financial investment horizon. This loss in the confidence made investors to seek for safest investment option which turned out to be the treasuries as rest all the other options still remained less safe in minds of investors.
Same reason can also be understood with the help of individual preference theory of microeconomics.
BaselineScenario.com comes up with interesting four figure illustration to prove this behavior of investors as rational in post Money as the Ultimate Giffen Good:
Imagine Mr. Midd L. Class owns an asset portfolio that has as projected wealth profile as described in the picture below. The blue dashed line is his expected wealth trend line (the average return on investments). The dashed grey lines represent the upper and lower bounds for Mr. Midd L. Class’ wealth at any given point in time. The solid red line is a level at which his wealth MUST not decline below, lest he face a major liquidity event or possibly even a subsistence event. (All of this can be expressed mathematically, but the math doesn’t add anything to the argument.)
At the start of time, Mr. Midd L. Class has a typical investment portfolio, let’s say 40% stocks, 40% bonds, 10% cash, and 10% other. Each of these investments contributes to the expected return and to the variation in the return (which we will call risk). Let’s say one of these asset classes (the riskiest) suddenly loses value. This can be reflected by shifting the trend line down, as in Image 2:
Note that this asset allocation is no longer acceptable to Mr. Midd L. Class because at some point in the future he runs the risk of dropping below the red line. Likewise, imagine that the expected wealth path remained stable but there was a sudden increase in the perceived risk of the safest of his investments (which increases the perceived risk of the entire portfolio). This might look like Image 3 below:
In either case (decrease in current wealth or an increase in risk of safe assets), Mr. Midd L. Class will seek an alternative asset allocation that meets his criteria (maximizes expected future wealth without risking a negative liquidity event). This will generally be accomplished by shifting the balance of his portfolio from high risk/high yield assets to low risk/low yield assets—in other words, selling stocks and buying Treasuries. In the case of Image 2 (caused by a decrease in wealth, such as a stock market crash), this will force increased selling even if the average expected return on stocks becomes higher. In the case of Image 3 (caused by an increase in the default risk of bonds), Mr. Midd L. Class will shift assets away from his riskiest assets (stocks) to his least risky assets (bonds and cash), even though the cause of the problem was the increasing risk of bonds. In both cases, as the effective price of bonds increases (when price is measured using risk-adjusted return), Mr. Midd L. Class will actually buy more bonds.
The income effect derived from the risk of falling below the red line (where utility is highly non-linear) dominates the substitution effect (the incentive to shift to higher yielding assets). Mr. Midd L. Class’s expected wealth trajectory now looks like Image 4, low yielding but safe. Mr. Midd L. Class also probably responds by reducing his overall consumption (which at the aggregate level reduces overall demand).
Macroeconomists might observe that none of this is inconsistent with some macroeconomic models, and this is true. If everyone simultaneously experiences a wealth decline and shifts out of riskier (higher yielding) assets, this decreases investment in riskier high return enterprise, and growth slows. Slower growth means less expected future supply, and less expected future supply means less present demand . . . and the vicious circle we all know and love. Macroeconomics reinforces this dynamic, but the natural experiment we all observed when the S&P downgraded US debt shows that it’s not just macro- but also microeconomic behavior that explains much of the pro-cyclicality in highly leveraged capital markets. Without the presence of massive leverage, the macroeconomic problems would still exist, but the pro-cyclical microeconomic factors would at least be dampened. This pro-cyclicality augments macroeconomic risk, and creates a very real cost to using a massively leveraged credit-based monetary system.