On the first trading day after the US credit rating was downgraded, the markets seemed to suffer from bipolar disorder.

The stock market was a bloody mess: the Dow Jones was off 634.76, its worst ever decline since the credit crisis in 2008!

The bond market, especially the treasuries market, which was supposed to take the brunt of S&P’s downgrade, responded positively. In fact, the 10-year treasuries yield dropped to a record 2.38%. The yields on long-term municipal bonds also dropped, to below 4%. This actually makes government borrowing costs lower, not higher. In a way, the bond market just thumbed its nose at S&P: to hell with your downgrade, we like US bonds even more.

Why the bond market reaction is important

The way the credit rating downgrade affects the US economy is through the bond market. Prior to today, pundits were speculating that the market would demand a higher yield to compensate for the increased credit risk, something in the magnitude of 25 to 50 basis points. If their predictions were to come true, the federal government would see its borrowing costs skyrocket by 10% to 20%.

The higher borrowing costs would filter down to state governments, commercial businesses, and private individuals (in the form of mortgage interest rates), making everybody pay more in interest. This could tip the US economy into a double dip recession.

The stock market, however, is where speculators get all panicky. It does not have a direct bearing on the underlying economy.

Why bond market and stock market reactions are so divergent

Robert Shiller, Yale economic professor, once said: 85% of the stock market movements is driven by emotions. The dominant emotion in hearing the first-ever US credit rating downgrade was fear. Fear needs an outlet, and that outlet is the stock market. Then, fear begets more fear since the stock market is what everybody watches closely.

Judging by the reaction of the bond market, I believe that the Dow Jones dropping 6% is a panicky reaction, not a cool-headed assessment of the US economy’s prospects.

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