Brad DeLong: FT.com / Comment / Opinion - S&P aims to whip Congress into debt action: A spokesperson for Standard & Poor’s said on Monday that there was an “at least a one-in-three likelihood” that the rating agency “could lower” its long-term view on the US within two years. US equities quickly dropped by more than 1.5 per cent. Importantly, however, the dollar did not weaken and US Treasury interest rates did not rise. The reason for this unexpected pattern is simple: the markets think this move is important not because it signals something fundamental about the economy, but because of the political impact it will have 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 higher, the future value of the nominal exchange rate is likely to be lower, and the possibility that creditors might not get their money back in the form and at the time they had contracted for had gone up. But if this were true the value of the dollar should have fallen on Monday. At the same time nominal interest rates on US debt should also have risen. The value of equities, meanwhile, could have gone either way: macroeconomic chaos would diminish future profits, but stocks have always been and remain a hedge against inflation.
But that is not what happened here....
Monday’s pattern makes sense... if S&P’s announcement is seen as a political move.... Normally the whip to get a deficit-reduction deal is fear of the bond market’s producing a spike in interest rates and borrowing costs, but perhaps a fear of a ratings downgrade will do instead.
Over the next few months we will see if the market is right.