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August 2, 2011

What Happens If The U.S. Gets A Sovereign Credit Downgrade?

By EconMatters

After the debt deal is done, I think the biggest suspense of the markets is whether the U.S. will get a downgrade from its current AAA rating by one or more of the three major credit rating agencies.  Both Fitch and Moody's re-affirmed the U.S.'s Triple-A rating, albeit with a threat of possible future downgrade.  It looks like Standard & Poor's (S&P) could be the lone holdout among the Big 3, but some think the major rating agencies would not act in such a 'politically incorrect' way.

Meanwhile, continuing its tradition of going against the Big 3 rating agencies, China's Dagong dealt a fresh downgrade to the U.S. from A+ to A despite the U.S. raising the debt ceiling and averting a default, while U.S-based Weiss already put the U.S. just two notches above junk.

So what happens if the United States does get a downgrade?

A downgrade would increase the borrowing costs. JP Morgan already estimated a downgrade would cost the U.S. government $100 billion a year. But the buck doesn't stop there, the higher interest rate and payments would trickle down to state, local governments, business and individual as well since most loan interest rates are benchmarked against the U.S. Treasury rate.

A downgrade could also have a negative impact on the dollar driving up consumer inflation, while diminishing consumer purchasing power. Moreover, the U.S. treasury accounts for a significant portion of many portfolios around the world, as it is historically the "safe" investment. A downgrade of the U.S. bond would have a serious wealth reducing effect on a global scale. It would also derail consumer and business confidence. No investment / spending equal no new job creations, which would make the unemployment situation even worse. (See graphic from McClatchy)  

Source: McClatchydc.com

Some economists think a downgrade would not be as traumatic since the U.S. debt/deficit problems and the possibility of a rating downgrade have been well telegraphed, and should have already been expected and priced in by the markets. So when the real downgrade comes, there would not be as much reaction. Another supporting fact--Japan lost its AAA status over a decade ago, but still enjoys relatively low interest rate.

They may have a point. Reuters quoted mutual fund data from Lipper that in the week to July 27; U.S. money market funds -- which primarily invest in Treasuries -- lost $32 billion, while high yield and investment grade bond funds attracted a combined $482 million. So, the markets might already be preparing for the downgrade by shifting some funds away from the U.S. bond.

However, I think the more important question is whether the markets would over-react when the new downgrade hits the news.  The debt situations in the PIIGS countries are also well known with all the data out there, but whenever there was a new downgrade from the Big 3 agencies, a market rout still ensued on whichever country in the downgrade news headline.

The S&P 500 has already been down for 7 days straight, the longest losing streak since October 2008, and crashed through the key 200-day moving average levels. The negative technical signs would suggest a potential market rout on any kind of negative news, particularly on one as historical and major as a downgrade of the U.S. sovereign credit rating.

So I think it is premature to say "a downgrade could resound in financial markets more with a whimper than a bang," because there will be consequences to pay as discussed earlier.  As to whether a downgrade will get handed down, politics probably plays a far more important role than whether the fiscal and debt situation of the United States actually warrants a downgrade action.    


Further Reading -

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