In early August, Standard & Poor's (S&P) downgraded the United States from AAA to AA, followed by subsequent downgrades to various securities backed by the U.S. federal government, including housing bonds collateralized by Ginnie Mae, Fannie Mae, and Freddie Mac.
One Out Of Three Isn't Bad
Despite the markets' volatile reaction in the week that followed, the news wasn't all bad. First of all, while disappointing, the downgrade wasn't unexpected. Second, the agency's "short-term" rating was affirmed, which basically means that there is no chance of the U.S. defaulting on its debt payments within the next year (the recent downgrade is based on a three- to five-year timeline). Third, the downgrade was a modest move to the next level, which is still considered an investment-grade rating. And fourth, the other ratings agencies (Moody's and Fitch) have not lowered their ratings at all.
Government Response
Many global economists, Wall Street analysts, and the White House administration lashed out at S&P's decision, calling the downgrade unfounded due to a $2 trillion error in its calculations of the federal budget, while S&P indicated that it was more influenced by the degree of uncertainty surrounding the political policy process. The Federal Reserve met shortly thereafter and responded in two ways. First, it announced it would keep rates low until 2013. Second, it did not increase capital charges for banks holding Treasuries.
Government-Issued Securities
As for Treasury bonds, the yield curve could steepen initially, but this is unlikely to deter the market's focus on the economy's slow growth and investors' continued flight to quality. In the credit markets, spreads are likely to widen in response to the downgrade, particularly for high-yield bonds. The downgrade will likely impact S&P ratings of securities within the municipal bond market in the near term, but the longer-term impact will depend more on the success of federal deficit reduction and any impending tax reform.
Mortgage Rates
Initially, news of the downgrade pushed mortgage interest rates even lower. For what is believed to be a short time before rates begin to creep up again, there is a window of opportunity for homebuyers and refinancers to apply for loans.
Money Market Outflows
While money market funds are generally considered to have a stable asset base, many are required to invest in AAA-rated securities. Therefore, the downgrade will require some atypical buy/sell adjustments in this market.
Equity Investing
The S&P downgrade is not expected to change the fundamentals of economic and earnings growth, both of which tend to have a greater impact on the markets. However, reactionary short-term market volatility could raise equity prices somewhat and potentially tighten price/earnings multiples. The good news is that conditions in companies both large and small are much different than they were three years ago. High-quality companies have reduced debt, increased margins, and boast healthy balance sheets. Any initial fallout can be attributed more to panic than true valuations based on technical factors.
The fact is, the recent S&P downgrade of U.S. government debt is probably not our most important concern. The bigger worry is slow economic growth and the constant threat of a double-dip recession. While a credit downgraded added to these concerns, what the U.S. needs now more than ever is more jobs to help improve consumer sentiment and spending, which in time should help the real estate market and battered home values. Enabling citizens to gain a financial footing may ease reliance on public entitlement and stimulus programs and help the government manage its debt reduction mandate.