The Rating Downgrade: A Natural Experiment in Finance Theory

Update: 10-year yields after one week: 2.25 (US), 2.33 (Germany), and 2.53 (UK). So now US yields will have to go up 90-100 basis points relative to Germany and UK to achieve Terry Belton's prediction.

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In my previous post I laid out the likely consequence of a downgrade of US debt under several views of how pricing works. Now that S&P has downgraded us, we have a natural experiment.

Per Bloomberg, JPMorgan’s Terry Belton says that a rating downgrade could raise US treasury yields by 60 or 70 basis points. If this is true, we should observe this over the next several days. But how do we distinguish between the effect of the rating downgrade and movements due to economic fundamentals?

There are basically two things that determine the yield on government debt: perceived risk and the availability of good alternatives. Thus a rise in yield could be good (meaning the economy is recovering) or bad (meaning the bond's perceived riskiness has increased). So if we want to attribute changes in US bond yields to changing perception of risk, we need some way of subtracting changes due to available alternatives.

The way we usually do this is by looking at spreads. So we can look at the spread between yields on US treasuries (say 10-year bonds), and those of some safe European countries, say the UK and Germany.

At the close of Friday, those yields were 2.69% and 2.35% , compared to 2.56% for the US (source). So the US was right in the middle of the pack, about 10 basis points below the UK and 20 points above Germany. If the US adds 60-70 points, we would be 50-60 points above the UK and 80-90 points above Germany. So that's a rough baseline.

Let's see where we are in a week.