– The first is not an additional comment but a repeat of what I said yesterday: S&P is 100% correct that the budget/debt issue did almost nothing to address fiscal sustainability. The big ticket items: Social Security, Medicare and Medicaid were specified as off-limits. Politicians placed getting reelected in 2012 above adopting a plan for fiscal sustainability. We do not need another commission. Simpson-Bowles did this and Congress and the administration chose to ignore it for political reasons.
– Tomorrow’s market reaction will be (I believe) much more serious in equities than in Treasuries. Equity buyers are more likely to react to media than fixed income (Treasury) buyers. High-frequency trading programs will perhaps test the the equity markets in a manner which they have not previously been tested.
– There is likely to be net inflow to Treasuries if equities sell off but we may see most of the flow go to the short (duration) end and a consequent yield curve steepening. Steepening is usually associated with concern about inflation but we could see steepening result from massive uncertainty.
– China. On Friday I had a lengthy phone conversation with someone I have known for over 40 years. He is in the shoe manufacturing business and spends a great deal of time in China. He stated that the Chinese people express a continuing displeasure with the heavy investments which China has in U.S. Treasuries. With China holding as estimated $900 billion in U.S. Treasuries it makes little sense for China to sell off U.S. Treasuries and drive down the value of that $900 billion portfolio. China’s expression of dissatisfaction with U.S. fiscal policy and its “downgrade” of U.S. Treasury debt is more about addressing internal dissent than it is about anything else. China also has its own economic problems. China has serious inflation. This has at least two causes: (1) The ridiculously low wages which China had been paying demanded increase and (2) China’s pegged currency exchange rate is not sustainable. China has adopted a “floating peg” but that is window dressing. The problem with the pegged exchange regime is that it allows China’s money supply to be a slave to the peg and that causes expansion of their money supply and inflation. China should give up the peg and float its currency.
China should address the problems created by the peg and let the U.S. address its fiscal problems.
– The worst outcome is not far-feched. U.S Treasuries could remain strong and the Treasury Department and those in Congress could then dismiss the concerns expressed by S&P and do nothing toward achieving fiscal sustainability. Congress cares more about reelection that it does about fiscal sustainability. If Treasuries tank, Congress is more likely to blame S & P than admit that the fault is with its own profligacy.
– I have been proposing for the past 5 years that we sever the deficit/debt ceiling issue from the rest of fiscal policy by placing control of the debt limit in the hands of a stand-alone non-political entity. Here’s a complete explanation.
– This downgrade is another reason to do away with FNMA and FHLMC and have private securitiation of mortgages. If a Treasury guarantee means nothing then getting the mortgage industry further distanced from the disasterous effects of policies such as HUD’s National Homeownership Strategy is to be desired.
– One last point about S&P itself. S&P along with the two other debt rating firms was 100% remiss in rating mortgage debt during the housing bubble. In the long run folks could realize that what S&P did on Friday was to rid itself if its habits about underestimating risk and S&P could – 10 years from now – be judged to have taken an heroic action.