Standard & Poor cut the outlook for US government debt from stable to negative on Tuesday, indicating that there is a 30% chance the US will lose its AAA credit rating. Such announcements increase uncertainty. Will the US pay its debts? Will it be able to fund its extravagant level of spending at manageable interest rates if the rating is cut?
The market has an instinctive response to increases in uncertainty: the ‘Flight to Quality.’ Fleeing investors sell assets perceived as risky (stocks, commodities, other stuff with big price swings), buy insurance against price declines for positions they continue to hold, and buy assets perceived to be safe (bonds, money market, etc.).
The Flight to Quality tends to be triggered too easily and too often, and it stays in effect too long. As a result, most investors hurt their performance if they succumb to their flight instincts. Nevertheless, it makes sense in principle to invest in safe assets during times of crisis and risky assets when the economy is humming along, it is just very difficult to execute in practice.
The current Flight to Quality is unfolding exactly as it always does. The first chart shows the S&P 500 over the last three days. The red line marks Standard & Poor’s announcement. Selling risky assets? Check!
The VIX Index measures how much investors are willing to pay for options that can be used to insure against stock losses. The second chart shows that the price of insurance jumped right after the announcement. Check!
And finally we need to look at buying safe assets. This is where this Flight to Quality should differ from the standard pattern.
Normally US government bonds are the safe asset of choice, but this time Standard & Poor is creating uncertainty by saying that US debt may not be as safe as previously thought. A smart stampede would avoid the source of uncertainty and flee to something safer. In fact, a smart stampede would sell US debt because it has become more risky rather than buy it as a safe haven.
The chart below shows the yield of a generic 10-year treasury bond over the last three days. The red line marks the announcement. Remember that yields move opposite of prices, so if the yield spikes up that means that prices plummet.
Right after the announcement, yields went up and prices went down as investors exited US debt. That’s the logical response to the outlook downgrade. But then the reflexive pattern of the Flight to ‘Quality’ set in as investors redeployed their funds into the traditional safe haven, even though it is exactly the asset class the rating agency had just warned them about.
Markets are extremely inefficient in the short term. This is just one of countless examples where psychology is trumping reason. However, in the long run a rating downgrade, if it actually happens, will drive up bond yields. Investors will reasonably demand higher yields as compensation for the higher default risk that comes with a lower credit rating.