Aspokesperson for Standard & Poor’s said on Monday that there was a one-in-three likelihood that the rating agency “could lower” its long-term view on US debt within two years. Equities quickly dropped by more than 1.5 per cent but, importantly, the dollar did not weaken and US Treasury interest rates did not rise. The reason for this unusual pattern is simple: the markets think S&P’s move is important not because it signals something new about the economy, but because of its political impact in Washington.
So what is going on? A sovereign-debt downgrade is supposed to mean that a government’s finances have become shakier. This means that the likelihood of internal price inflation is also higher, while the future value of the nominal exchange rate is likely to be lower – with the chance that creditors might not get their money back in the form and at the time they had envisioned.
If all this were true, equities could have gone either way: economic chaos diminishes future profits, but stocks are a good hedge against inflation. However the value of the dollar should certainly have fallen, while nominal interest rates should have risen. But that is not what happened.