Wednesday, August 10, 2011

So why did US Treasury yields drop post the ratings downgrade?

So if US treasuries are not risk free, then why are the yields falling and there continues to be a huge demand for US government debt?

The answer is that it is not about absolute but about relative levels of risk. The perception (or reality) is that if the US government is risky, then lending to any other government is perhaps riskier. And the difference (in perceived risk) just became even more pronounced.

What is probably going to happen is that US domestic funds would continue to buy treasuries (as they would have a tough time trusting any other country) even though investors from outside of US (and their respective central banks) would start to pull out of reduce incremental exposure to US debt.

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