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US rating downgrade ‘meaningless’ from financial and economic perspective

As a parent I can’t tell you how many times I have warned my rather stubborn four-year-old daughter to “stop doing something or I’ll put her in time out”.

Being a rather “independent” child she often discounts my initial threat and attempts to “push the boundaries” in various ways. This may go on for a bit but even I have my limits. Just like my daughter, the politicians in the US have ignored the various ratings agencies who warned them that if more substantial measures were not taken to control their irresponsible spending and the poor fiscal monetary policies a credit rating downgrade was likely. This time Dad has had enough - the US just got placed in “time-out” where they will need to “face the wall” and seriously think about what they were doing. On Friday night, Standard & Poor’s (S&P) issued the following statement:

“The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation programme that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.”

With this statement the reserve currency of the world received a downgrade to AA+ with a continued negative outlook. The US had been rated triple “AAA” since 1941.

Not surprisingly, as most parents would expect, the misbehaving children who now have realised Dad is serious, immediately resorted to making excuses and outright denial. The Obama administration immediately chastised S&P and pointed at what they believed to be a miscalculation in the data which was acknowledged by S&P but did not change the punishment. It should probably not be so much of a surprise given that any country that has so recklessly spent money in such a fashion and given no heed to Dad’s frequent warnings probably should have been downgraded long ago.

The real issue here might surprise you: this downgrade is actually meaningless. I mean this strictly in a financial and economic basis of course. The symbolic nature and blow to American pride is meaningful in itself. However, in terms of seriously altering the US government bond market standing in the world - the downgrade was meaningless for a couple reasons. Let me explain.

First, the only credit rating agency in the world that matters is the bond market itself. The bond market has been telling us that over the past two months or so that the whole debt ceilings default issue was not a risk at all. During this whole debacle the bond market continued to be willing to lend the United States at ever decreasing rates. This tells you that the world is willing to buy US debt at steadily lower levels even with its “bad behaviour”. It also tells you the market was never worried about the US’s ability to pay its obligations. The US is not Greece or Ireland; it can print its own money and therefore technically cannot default on its debt. If the bond market was truly worried about a default over this time US government rates would have already moved significantly higher.

Second, S&P has stated that ”it is possible that interest rates could rise if investors re-price relative risks. As a result, our alternate scenario factors in a 50 basis point (bp)-75 bp rise in 10-year bond yield...”. If this were the case rates would rise this week back up to where they were at the start of the year. I don’t think this will happen. In fact two things will need to incur to see a substantial sudden rise in rates. The first is that the world suddenly losses faith in the US as a reserve currency and makes a move to another different currency because the bond market seriously doubts the US’s ability to pay its debts and meet its obligations. This would be extremely difficult given the sheer size and liquid nature of the US treasury market. Whether its “AAA” rated or “A” rated, there is no other country in the world that could accommodate the size needed for reserves. Nor would any other country likely want to be the new reserve currency at this stage. If China, for example, became the reserve currency it would surely not appreciate a rapidly strengthening yuan that would hamstring its export based economy. Thus it is likely they, not out of kindness but out of necessity, would continue to buy US treasuries rather than convert US dollar sales into yuan. The other factor that typically would raise interest rates would be a strengthening US economy. If I can make a six percent return on investment, treasury rates will need to rise to this level to attract my investment. Basically, as the demand for treasuries falls rates will eventually rise to attract investment. The economic conditions are far more important in the near term.

This is why this downgrade will ultimately be meaningless as the market will soon forget it and begin focusing on Italy’s woes or the potential for a recession in the US. Other than a small uptick in rates next week (maybe due more to correcting a very over-bought condition in the bond market) this downgrade will likely have no material effect. Unfortunately, this time-out may not have altered the kid’s behaviour for the better.

FILE - In this Aug. 5, 2011, file photo a pedestrian walks past the New York Stock Exchange on earl in New York, a day stocks around the world tumbled ahead of crucial U.S. jobs figures. Anger at the nation's leaders for taking so long to strike a debt-ceiling deal has turned into high anxiety over jobs and the economy amid growing fears of a new recession. Standard & Poor's downgrading of the nation's credit rating a notch for the first time ever only added to the tension. (AP Photo/Jin Lee, File)

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Published August 08, 2011 at 10:15 am (Updated August 08, 2011 at 10:14 am)

US rating downgrade ‘meaningless’ from financial and economic perspective

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