US debt and the S&P downgrade

Today, ratings agency S&P downgraded the outlook for US debt to negative — surprising nobody who has been paying the least bit of attention during the trillion-dollar race to the bottom. Aside from the psychological aspects of the downgrade, this is S&P’s way of saying there is a 1 in 3 chance of a downgrade from AAA within the next two years.

We make a living calculating the product of probabilities and magnitudes of risk — then hedging off the largest of those products. In that arena, this downgrade looms large. Granted, a 1/3 chance of a downgrade is a small (if not quite remote) probability. The magnitude of such a downgrade, were it to occur, is so great that I’m not sure we can fully understand its impact. So, when we multiply the immensity of the “expected magnitude” by the “known probability” of 33%, we come up with a number far too large to ignore.

While this blog does not (nor will it ever), give investment advice, we wonder what else can possibly be needed for interest rates to begin rising. ZIRP cannot exist in perpetuity, QE2 is nearing its end, and US debt is on a negative credit outlook. If we weren’t “through the looking glass” in our financial markets, selling Treasuries short with the expectation of higher rates would be a lay-up trade. Yet, as I was typing this, I glanced over at the Bloomberg… and all maturities of Treasuries have lower rates now than they did before the downgrade.

Someone once said “Love conquers all.” I think that should be changed to “Permanent Open Market Operations conquers all.” I have nothing against love, but in pursuits where emotion and hopefulness trump logic (as it is for both love and open market operations), POMO has a much better track record.