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The unintended consequences of the Treasury downgrade



Last month I had a post on the likely consequences of a Treasury downgrade, and it now looks prescient. Those who are unfamiliar with the law of unintended consequences might have thought that a Treasury downgrade would make Treasuries less attractive, driving up their yield. Now we know that just the opposite has happened: Treasury yields have plunged in the wake of the downgrade. But there's more to the story, since the plunge in Treasury yields has been accompanied by a surge in the yields of junk bonds. The explanation for why this has happened is in the post referenced above. The short answer is that a Treasury downgrade has reduced the average quality of the world's bond portfolios, and many of those portfolios are being forced to sell their low-quality bonds and buy more Treasuries in order to bring their average quality back up to where they want it.

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