Standard & Poor's expected Treasury bond downgrade

I agree with the S & P downgrade (if advance reports are accurate) in substance. That is, the U.S. has a significant chance of default because of political dysfunction, in particular the Republicans' recently demonstrated callousness about our credit standing and their unwillingness to increase tax revenues under (apparently) any circumstances.

But it's certainly not obvious that the market should care about the downgrade. When major U.S. companies issue bonds, S & P actually has some inside information if they've been consulted during the rating process. There may be conflicts of interest and the smart guys on the other side may snow them, but at least they get to see things that aren't publicly available. As I noted in an earlier post, this is not true in the government bonds setting.

Here's a somewhat farfetched theory as to why the market may care. S & P's willingness to downgrade, as a bid to enhance their "brand," is evidence that they think people in the audience for their performance will consider the downgrade credible. So if I am in the bond market, it is a bit of a Keynes beauty contest thing - someone with a real (reputational) stake has decided that others who are in the bond market will view this as a credibility-enhancing play. Note that pessimists may not directly participate in the market as much as optimists if the market is incomplete because it is costly to go short.

Nonetheless, I'd be unsurprised if there is no market response to the downgrade.