S&P downgrade of US credit rating has benefitted US treasury yields the most. In one stroke S&P has brought down yields on the ten year treasury by 60bps. The ten year yields are now trading at lowest levels seen since December 2008. The US yield curve too has flattened by 60bps on the back of the S&P move. The two over ten treasury spread has come off from 260bps to 200bps since the downgrade. US bond yields are clearly factoring a period of low inflation and low growth. The US Federal Reserve (Fed) has pledged to keep rates at 0% to 0.25% till mid 2013 on the back of perceived weakness in the US economy.
The Fed saw weakness in the US economic recover in mid 2010 and embarked on a USD 600 billion US government bond purchase program (QE2) to bring down long term rates to take the economy out of the woods. The Fed bought long dated US treasuries from November 2010 to June 2011 in order to bring down long bond yields and pump in liquidity into the system. The Fed’s bond purchase had an opposite effect to long bond yields. Bond yields moved up by 100bps since the time the Fed started bond purchases.
The effect QE2 had was a rise in inflation expectations due to Fed’s printing of money. Bond yields in the US started trending down from May 2011, when doubts to economic recover cropped up. Unemployment rate stagnant at 9.2% levels, revision of 2011 GDP forecast by the Fed from 3.1%-3.3% to 2.7%-2.9% and worries over the growth in Eurozone due its debt problems, started taking down bond yields. The fact that the Fed ended the QE2 in June and did not announce a fresh one took its toll on growth expectations.
The US government too contributed to the decline in bond yields by haggling over the increase in debt ceiling. The debt ceiling bill was passed one day before a bond repayment date. Then came the S&P downgrade from AAA to AA+. S&P cited insufficient cuts in fiscal deficit as the reason for the downgrade.
US ten year yields are at three year lows of 2.18% and given the current reading of the US economy by the Fed (low growth, low inflation) the ten year bond yield is likely to decline further. The Fed tried to achieve this effect by printing money to buy long date US treasuries and failed. The QE2 did not have a long term effect on the US economy as seen by the revision in GDP growth forecast. Hence the efficacy of quantative easing is questionable.
The fall in long bond yields will have positive effects down the line. Borrowing costs come down for mortgages as well as for long gestation project finance. If inflation stays well below targets for a while the Fed need not do anything except keep rates at all time lows and maintain sufficient liquidity for the economy’s needs. Embarking on a QE3 is not a solution especially if it takes up long bond yields.
S&P has done the US a favour though policy makers there think otherwise!