On August 5th 2011 Standard and Poor’s downgraded the United States’ credit rating from “AAA” to “AA+.” This was unprecedented. All of a sudden the United States was rated lower than Automatic Data Processing (NYSE:ADP), a large but ho-hum payroll processor.
If I revert back to my finance and economics textbooks, all of them would predict that if someone gets downgraded the price of their debt would go down, and the yield would go up. Let’s break that down. If Company X owes debt to someone, and let’s say they pay 10% annual interest on that debt, and then they get downgraded, what does that mean? For Company X, the debtor, it means that they would have to pay more than 10% annual interest because now they are a riskier proposition. For the creditor of Company X (that is the person who Company X owes) the value of the debt that they hold should go down because it pays 10%, while any new debt that Company X will offer should pay a higher rate, maybe 12% or 15%, for example.
When S&P’s downgraded the U.S. the fallout should have been higher yields, in other words, all the bond investors in theory should have demanded that Uncle Sam pay more interest in exchange for a bet on the U.S. of A. That didn’t happen.
What happened was the opposite. Investors panicked when the U.S. downgrade occurred. Once the panic began, investors made the proverbial “flight to safety” which for now still happens to be U.S. treasuries.
Think about it. People lost confidence in the solvency of the U.S. A., they panicked and made some knee-jerk reactions, driving the price up (and the yield crashing down to about 2%) of the very thing they were worried was going to go down.
Sure this example was from five years ago. But this is the world we find ourselves in. It is a world of greater peace. We swim along knowing that violence is statistically less likely to occur against us as it was against our grandparents. But it is a world of yawning contradictions. Sometimes it is crazy and hard to explain. Remember the metaphor of the shield coming against the spear, maodun (矛盾), this convex vs. concave contradictory force. When I think of contradictions, I don’t think it is easy to find the harmonious center position, and hold steady, trying to displease as few people as possible. Actually, that might be poorest approach at all. The distressing news with contradictions is that there is no one prescribed way to address them. The spear and shield are helpful images, because they illustrate that no matter what, sometimes you better take a step back lest you be squished.