This post is contributed by StatsGuy, an occasional guest contributor and commenter.
Monday August 8 2011 witnessed a truly impressive financial spectacle—a natural experiment of the kind we see only once a century or so. The S&P downgraded US debt, and the price of US Treasuries skyrocketed.
Many pundits were left scratching their heads. Professional traders tripped over themselves trying to get out of the way. Macroeconomists at least had an explanation, arguing that the downgrade meant substantially lower growth, and this forced people to shift into Treasuries since bonds rise when growth projections diminish.
While some macroeconomists have an inkling of what is going on, I suspect they got their causation backwards. Why would an increase in a risk rating on debt directly lower growth projections? Usually, the increases in risk ratings cause increases in interest rates, and it’s the rate hikes that harm growth. But, um, nominal interest rates went down, right? Shouldn’t that have helped growth? More sophisticated economists will note that when they talk about rates, they mean the real rate (adjusted for inflation), and that if inflation expectations drop more than nominal interest rates, then real interest rates go up and this will slow growth. However, this did not happen—real interest rates actually declined about 0.2% along most of the yield curve between Monday the 8th and Tuesday the 9th. And if real rates declined, how would this cause lower growth? Instead, I suspect the decline in real rates was the outcome of lower expected growth. It’s all very circular and confusing, but at least I’m not alone. Others seem even more confused.
For example, Dick Bove said: “We have people buying Treasury securities because they’re worried about the Treasury. We’ve got people selling banks stocks, taking the cash and putting into the banks for safety. It doesn’t make sense. What you’re seeing is this adjustment is occurring and people are not sure how to react to this adjustment.”