Market reaction to potential U.S. rating downgrade

Standard and Poor’s Monday released analysis Monday revising the outlook on U.S. debt to negative. “Our negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years,” Mr. Swann said. “The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012.”

Treasury Secretary Geithner responded that there was no risk of a downgrade.

Brad DeLong has a nice analysis in the Financial Times of the market reaction: stock market down, dollar and long-term treasuries unchanged. If S&P’s action caused market participants to increase their assessment of the risk of either default or a significant increase in inflation, we might expect lower stock market, weaker dollar, and higher interest rates. DeLong argues instead that the market took the S&P action as a nudge toward resolving the budget problems. Thus, this was good news for the dollar and interest rates and bad news for the stock market due, perhaps, to the short-run effects of fiscal contraction.

DeLong gives a lucid account of how economists interpret market reaction to news: “there are two things to bear in mind. First, you can go insane over-interpreting short-term market movements. Second, news comes in flavours: new news, old news, no news and political news. And we need to understand why this is news of the latter variety.”

I completely agree. Creative economists can almost always come up with a coherent story for any pattern of market reaction to news. Placing too much emphasis on any given reaction is not a good idea.

It is better to focus on the overall pattern of market reactions to different news over time. Often that pattern is much richer than the simple stories we can form regarding the reaction to a single bit of news. This is one conclusion Jonathan Wright (of the CFE) and I found in research with John Rogers and Shing-Yi Wang: “The High Frequency Response of Exchange Rates and Interest Rates to Macroeconomic Announcements”