Why the S&P Downgrade Is Good for Treasuries

So why is the initial reaction of the S&P downgrade of Treasuries for Treasury bond market prices to go up?

The S&P downgrade was not as much a comment on the numbers of credit service as a comment on the political process. The political process is about confronting the probability of a hyper-inflationary collapse of our currency if our fiscal irresponsibility, entitlement spending and bank bailout mentality are not addressed.

If the credit rating firms had continued the charade of AAA quality, it would merely enable the not sustainable march toward hyper-inflation. Ultimately, the S&P downgrade of Treasuries is a downgrade of all dollar denominated assets. If we can print dollars to pay Treasury debt, it is the currency that is at risk.

A nominal default of Treasury obligations is not going to happen. Yet, a real default as a currency event is the risk. In order to save the currency, we must sacrifice the money center banks. A sacrifice of the international banking system is a deflationary event.

For Treasuries to rally in a flight to quality as a market reaction to their own downgrade is a flight to the relative safety that remains. Anticipation of the deflationary political discipline of an S&P downgrade is the rational reaction of capital flight away from securities propped up by the reflationary status quo.

Since the U.S. and European governments' reaction to the 2007-2009 private sector credit crises was to reflate bank collateral assets by replacing the private sector credit bubble with a public sector credit bubble, the limits to this misguided reflationary policy are now more political than financial. Policy choices are clearly between a deflationary deleveraging/purging of malinvestment or a reflationary protection of the status quo international money center banking system to the detriment of wage earner and pensioner standards of living. Reflationary policies of fiscal and monetary stimulus are increasingly viewed as a bi-flationary regressive tax. The shotgun approach of monetary policy harms people to save banks.

Demographics of the developed world have led to the legacy banking system reaching for return outside of domestic economic growth. European banking system assets far exceed those justified by domestic activity. This over-reach by the legacy system is compounded by the various erroneous Keynesian monetarist schemes of credit promotion that have now saddled the U.S. and European system with uneconomic credit. Rather than recognize this policy error and allow the eradication of this excess credit in a deleveraging process, the powers of the status quo have chosen to compound their error with a public sector credit bubble.

In the near term an S&P downgrade of Treasuries lowers the probability of a U.S. bailout of the European banking system. The European banking system is the vortex of the deleveraging process. Their relatively large assets to GDP makes them vulnerable. The lack of a European political institution to complement the monetary union of the Euro hobbles the resolution process.

This downgrade exposes the limits of U.S political capacity and its mandate to manage the international financial system.

One would think that the reaction of our Asian and Arabic creditors would be to avoid our debt. Yet, in the short run they recognize that the liquidity of dollar assets still commands a premium over alternatives. It is the long run implications of loss of world reserve currency status to precious metals wherein the market reaction lies. These creditors are sick of the dollar recycling system and cheer on Standard & Poor's for accelerating an alternative.