This was inevitable, wasn’t it? China is the world’s largest holder of U.S. debt, and now it is holding downgraded debt.  China is not happy, as you can see in this report on Marketwatch.com:

“The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone,” China’s state-run Xinhua News Agency said Saturday, in Beijing’s first official response to the S&P action, according to wire service reports.

“China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s dollar assets,” it said.

I love the simplicity of that language: “the good old days when it could just borrow its way out of messes of its own making are finally gone.” There is so much truth to that statement that I think we should borrow 50 or so Chinese Communists to serve in the U.S. House and Senate. That is how bad things look in U.S. politics.

But China lecturing the United States on its fiscal policy – no matter how deserved – probably won’t help. Will we see a backlash response from the U.S.? Probably not, since China sits in front of a big pile of money in this poker game. In fact, the U.S. and China are economic partners, sort of an ‘arranged’ marriage.

What about TIPS? Treasury Inflation-Protected Securities, as measured by the TIP ETF, had a wild 5 days last week but ended just about where they started, and still near all-time highs:

But that price swing was relatively minor in last week’s wild market:

Next week, despite the S&P downgrade, TIPS could stay relatively stable if the stock market continues its sharp decline. If stocks rebound, as they did Friday, TIPS yields could begin rising, because the ‘safe haven’ attraction is dimmed. Even if the S&P downgrade resulted in a 50 basis point increase in TIPS yields, that would just bring the yields back to April levels.

For holders of the TIP ETF (I don’t own it), a 50 basis point increase in TIPS yield would result in about a 2% drop in NAV, hardly a disaster.

Eventually, TIPS are going to have to reflect the new reality: The economy is possibly heading toward another recession, and inflation may not be a threat in the short term.

Or … will the Fed step in with QE3 if the economy tanks (giving TIPS a boost)?

Upcoming auction. The uncertainty makes the Aug. 18 reissue of a 5-year TIPS especially unattractive, in my opinion. The likely real yield has been wavering well below  the all-time low of negative 0.55% in October 2010, right before the launch of QE2.

Friday’s yield, after TIPS took a hit, was negative 0.676% for the 5-year TIPS maturing July 15, 2016.

The auction announcement will come Aug. 11.