You could be forgiven for believing the media hype recently concerning S&P’s downgrade of U.S. debt from AAA to AA+. It sounds believable! If we’re no longer AAA, we can no longer serve as the world’s reserve currency, so everyone will dump our bonds. As selling overwhelms buying, bond prices fall, and bond yields rise, which further crimps our struggling economy.
However, history shows that the opposite happens. Bond prices rise, and yields fall, over the first 6 months and the first year after the downgrade. For the 9 countries (11 downgrades) which faced a drop from AAA to something else, the average drop in the country’s 10-year government bond yield was 0.49% after 6 months, and 0.75% after 1 year. Why??? Probably a couple factors. First, while AAA is good, AA or AA+ is still good, too. Bondholders found little reason to abandon a credit rated AA+. That should explain the lack of selling. Second, what could explain the drop in bond yields is that the downgrade fans concerns not so much of the survival of an economy, but of its growth. This results in a flight to quality from risky assets to bonds.
The local stock market has been, on average, 3% higher 6 months following the downgrade, which is probably better than you would have expected, but still not that great. And there were more down markets (6) than up markets (5). But perhaps the fears of a lack of growth fail to materialize, because only 3 of those 11 markets stayed down after 1 year, and the average return was +17%. So far, the U.S. bond market is toeing the company line, as the 10-year treasury yield has fallen 0.49% in just the last 3 days, exactly in-line with the average of the other 11 countries. But the stock market has some catching up to do.