Treasury market improves initially after downgrade?

After last Friday’s S&P downgrade, people expected the markets to decline today, and so far, that prediction has been fulfilled. European and Asian markets have already seen significant drops in advance of Wall Street’s opening:

Global stock markets sank again Monday as worries over the downgrade of U.S. debt outweighed relief at a European Central Bank pledge to buy up Italian and Spanish bonds to help the two countries avoid devastating defaults.

European markets shed their early momentum and losses were heavy in Asia. Most stocks were trading sharply lower amid mounting fears over the opening of U.S. markets, when traders will have their first chance to respond to Standard & Poor’s momentous decision to lower its triple A rating for the U.S.

“The reverberations from S&P’s downgrade are still being felt across the globe,” said David Jones, chief market strategist at IG Index.

The futures market in New York took a dive before the NYSE’s opening bell:

Wall Street was set to track a sharp drop in global equity markets on Monday after rating agency Standard & Poor’s cut the top-tier AAA credit rating of the United States, rattling already-jittery investors. …

The impact of S&P’s rating cut was felt in Asia and Europe. Japan’s Nikkei stock average <.N225> slid 2.2 percent at the close on Monday, while the FTSEurofirst 300 index <.FTEU3> of top European shares fell 2.1 percent in early trading. MSCI’s all-country world stock index <.MIWD00000PUS> dropped 1.2 percent.

In U.S. trading, market sectors most sensitive to the economy, such as the banking and natural-resource sectors, were set to take the brunt of selling. United States Steel Corp fell 5.8 percent to $31.30 in premarket trading, while Citigroup Inc dropped 4.8 percent to $31.82.

And all of this had an interesting effect on the maligned US Treasury bond market.  Despite the focus on the downgrade of its rating, the yields went in a surprising direction this morning, at least so far:

So far, the S&P downgrade doesn’t seem to be having too much of an impact on U.S. government bonds, known as Treasuries. The worry has been that the downgrade would prompt investors to demand more, but the yield on ten-year Treasuries has actually fallen.

“Early market reactions suggest that the treasury market will remain well supported,” said Jane Foley, an analyst at Rabobank International. “Even though there may be no sharp sell-off in treasuries this week, S&P’s decision should at least provide a signal to the U.S. government that it may be foolhardy to continue to take its creditors for granted indefinitely.”

I hate to say I told you so, but … actually, I love to say I told you so.  The problem in the markets now isn’t the downgrade to Treasuries, but the overall economy and the debt structure of the entire West — especially Europe.  While the US faces a long-term debt structure that is absolutely irrational and unsustainable, the EU seems to be falling apart now.  Greece, Italy, Spain, Portugal, and Ireland are all on the cusp of a real default, not a political delay in making payments.  Germany is practically floating the entire continental economic system, and it’s anyone’s guess how long the Germans will put up with that situation.  Japan’s debt load looks worse than ours.

Under these conditions, downgrade or no downgrade, bond buyers will still seek out US Treasuries first.  With the stock markets tanking on the instability of the EU and a slowing American economy, bonds are the natural haven for sellers.  Since we aren’t having to offer higher interest payments for our bonds, the rest of the predicted economic consequences of the downgrade will likely be highly mitigated or not arrive at all, at least not in the short term.

That doesn’t mean that the S&P downgrade shouldn’t be taken seriously.  We have enormous, real, and disastrous debt-structure problems, especially in entitlement commitments for the next few decades, which will ruin our economy if not corrected soon.  But the sky-is-falling hysteria in the short term is simply unwarranted, even if useful to get people to stop rewarding the demagogues who keep preventing a rational debate over unfunded (and unfundable) liabilities in Medicare, Medicaid, and Social Security.

Update: More from CNBC’s Jeff Cox, who headlines this result:

Standard & Poor’s spoke loudly and clearly when it downgraded US debt, but the Treasury market on Monday didn’t appear to be listening.

While stock markets were selling off around the world bonds rallied. The 30-year bond gained more than a point in price as investors sent their own clear message that in times of turmoil, Treasurys were still the safest house on the block.

The movements seemed to suggest that S&P, for all the bluster and bold headlines its move created, was not calling the shots.

Perhaps, perhaps not, but the real lesson is that investors don’t see the real crisis as being in US Treasuries.  They’re more worried about the overall economy and the acute debt crisis in the EU, and they should be.

Update II: Conservative Commune has more.