And so, S&P has decided to cut US debt rating, essentially stripping the T-Bills of its risk-free status from S&P’s perspective.[1] This is likely to trigger other agencies to follow suit. Theoretically, this has wide implication because risk-free asset is an important basis in asset pricing.
Although the cut is expected, I am maybe dissatisfied at the wide influence of rating agencies. Yields of the debt were relatively low before the cut despite everything that we know. What will make me positively dissatisfied is if yields increase after the cut. We will have to wait for Monday for that.
In that case, increase in yields after the announcement of the cut will feel artificial. It will feel inefficient in terms of information dispersion.
It will be dissatisfying because market players will mainly react to the cut rather than directly to the financial health of the issuers.
Perhaps through some kind of procedure or programming demanding risk-free status, the downgrade by S&P may trigger a rush out of the bonds (to where is a harder question to answer). If the S&P did not issue a downgrade, yields will probably be low still. So, the implementation of the rule that funds have to hold the highest rated debts rated by these agencies divorces its outcome from what an ideal free market outcome.
I would think a more efficient approach would see market players responding to the quality of the bonds even before S&P’s announcement. Yields should have gone up before the announcement. This has happened in some way as reported by the article at the New York Times, but not with the speed that I think is identifiable to efficient market in terms of information.
One could say that S&P is part of the market. One could say that S&P reacted to the health of the issuers and market participants only reacted accordingly by trusting S&P as the arbitrator of ratings, never mind the credibility of S&P and other rating agencies after the subprime crisis. S&P with its specialized skills helps distribute the relevant information as efficient as it can.
But the ideal outcome will not rely on just S&P, or any one rating agency. There are thousands if not millions of players out there. An efficient market would preempt any decision by these rating agencies: after all, the information these agencies rely on are very public information. Yields should have gone down earlier before the announcement.
If yields rise on Monday, that may suggest that rating agencies have too much power to decide on behalf of the market, a market which is more diverse than a couple of rating agencies. It will also suggest that the market is inefficient. To put it more clearly, an efficient market would have these agencies lag behind market sentiment, not the other way round.
[1] — WASHINGTON — Standard & Poor’s removed the United States government from its list of risk-free borrowers for the first time on Friday night, a downgrade that is freighted with symbolic significance but carries few clear financial implications. [Binyamin Appelbaum. Eric Dash S.& P. Cuts U.S. Debt Rating for First Time. Wall Street Journal. August 5 2011]