Spooked investors flee to safety of — Treasuries?

The standard flight-to-quality move took an odd turn yesterday, when the markets were jarred by a negative outlook for the United States' AAA debt rating. In typical fashion, the risk-on mindset sent investors running from stocks and toward Treasuries. That wouldn't be so strange if it weren't for the fact that Treasuries were the source of the newly perceived risk, according to the Standard & Poor's Rating Service, which announced a 33% chance of downgrading the U.S. credit rating in the next two years. Thus, as the S&P 500 Index wrapped up the day down 1.1%, the yield on the10-year Treasury, which is driven downward on investor demand, fell by 1.14%. “I understand why people use Treasuries as a safe haven, but you can't use them as a safe haven if the problem is Treasuries,” said David Kelly, chief market strategist at JPMorgan Funds. “It's a strange and illogical result,” he added. “Either the bond market should have sold off more, or the stock market should have sold off less.” To be fair, there were other factors influencing the stock market selloff yesterday, including new concerns over European sovereign debt. But with market watchers generally citing the S&P announcement as a driving force behind yesterday's stock market dive, it is almost comical how instinctively investors piled into Treasuries to flee the risk associated with, yes, Treasuries. From Mr. Kelly's perspective, it boils down to an extreme level of complacency with regard to government paper, which has been on a near 30-year rally since the 10-year Treasury peaked at 15.84% in September 1981. “Nothing breads complacency like a long bull market, and that Treasury rally [yesterday] was testimony to the complacency,” he said. The United States has never lost its AAA credit rating. Still, the threat of a downgrade for a country currently running a $1.5 trillion deficit and carrying $9 trillion worth of debt is a worrying thing. While most investors can't really fathom the enormity of owing – let alone spending – trillions of dollars, it is safe to assume the country's fiscal condition is not news to most people. Granted, there is some shock value of a major rating agency suggesting the U.S. might be placed on a watch list of risky creditors. Still, it doesn't really merit the kind of market reaction unleashed yesterday. Ultimately, investors should perhaps think of yesterday's panic as a test. And we can all be grateful that is was not an actual emergency. As yesterday's stampede into debt instruments with a 1 in 3 chance of being downgraded indicates, our instincts aren't always so hot.