Implications of the S&P Downgrade

On Monday, we took a look at what has happened historically to the bond market after a nation has had its debt downgraded. Early signs looked great for Treasuries, as investors poured money in, causing prices to rise and yields to fall. Today, we'll take a deeper look at the implications this may have for both the stock and bond markets.

Before launching into the implications, there are a few important reminders about the downgrade itself. First, Standard & Poor's sent a message that our problem (unlike Greece, which has an economic problem) is simply one of having the political will to take the actions needed to change the trajectory of our debt-to-GDP ratio. S&P did affirm its A1+ short-term rating and removed both the short-term and long-term rating from CreditWatch negative.

Also, it's important to note that the other two rating agencies -- Moody's Investors Service and Fitch Ratings -- affirmed their AAA credit ratings on August 2, the day President Barack Obama signed the bill that ended the debt-ceiling impasse. However, Moody's and Fitch did say that downgrades were possible if lawmakers fail to enact debt reduction measures and the economy weakens.

This Isn't S&P's Fault I've heard some people trying to place the blame on S&P. Blaming S&P for the downgrade doesn't make sense. S&P had given clear warnings months ago by placing Treasury debt on negative warning. And the world already knew we didn't deserve a AAA rating, because we had failed to take the steps needed to avoid it. Credit-default swap (CDS) spreads were already indicating this -- the capital markets are always ahead of the rating agencies, which are a lagging indicator.

Another great example illustrating that Treasury debt had lost its special position involves the one and only Warren Buffett. As long ago as March 2010, Berkshire Hathaway's debt traded at a lower yield than the similar maturity Treasury, meaning the market viewed Berkshire Hathaway debt as safer than U.S. government debt. At the same time, Moody's issued a warning that the U.S. was moving "substantially" closer to losing its AAA rating.

The deal to avoid default didn't deliver significant immediate cuts, and Congress's ability to deliver on future cuts has no credibility with anyone. To prevent the debt-to-GDP ratio from continuing its upward trend, about $4 trillion in real cuts was needed. We didn't get anywhere near that. The bottom line is that the downgrade is a result of the problem, not the cause.

Photo courtesy of wwarby on Flickr.

• Next: Implications for Markets

As we discussed yesterday, there hasn't been a significant impact on other countries that have seen their AAA ratings downgraded. Japan and Canada are two examples. However it's important to note that the impact of the downgrade could be slower economic growth, which can have the opposite effect on borrowing costs. In addition, the crisis could lead to flight to quality and liquidity (with Treasuries being the most liquid asset in the world), away from weaker credits like junk bonds and to safer investments (like Treasuries). Thus, it's hard to forecast what the actual impact of the downgrade will be.

Another important point is that U.S. banking regulations give Treasury obligations a special status not contingent on their rating. The Fed affirmed that status in guidance issued to banks on Friday night. Some investment funds, too, often treat Treasuries as a separate asset category, so these funds would not need to sell Treasuries simply because they're no longer rated AAA.

Also, the downgrade may lead to a sell-off in riskier bonds. Barclays noted that 76 percent of the Barclays Aggregate Bond Index is made up of AAA-rated assets, with 44 percent in Treasury and government-related securities. With the U.S. downgraded, bond funds would have to sell lower-rated securities and purchase higher-rated ones to maintain the average rating. Barclays estimates that funds could be forced to sell as much as 30 percent of their BBB-rated securities.

There's yet another consideration. The Asian central banks are among the largest holders of Treasury obligations. Recently, the falling dollar has lured them into buying Treasuries to prevent the dollar from falling against their currencies, which impairs their export competitiveness. China has now accumulated $1.2 trillion in Treasuries, and Japan's intervention this week -- estimated to be in excess of $51 billion -- presents a potential new source of demand. China has accumulated its Treasuries holdings by restraining gains in its currency, the yuan, which has risen less than 3 percent against the dollar this year. By comparison, the Swiss franc has soared 22 percent, New Zealand's kiwi is up 8 percent, and the yen advanced 3.5 percent. Other countries such as South Korea also may decide to take actions to prevent their currencies from rising.

Finally, it's extremely important to keep the following in mind. The U.S. doesn't have any foreign-currency denominated debt. The inability to raise the foreign currency needed to pay foreign-denominated debt is typically the trigger for sovereign governments defaulting on their debt. Since we have no such obligations, we can (and will) print money to pay off our debt (if necessary). There's no reason for the U.S. to ever default on its dollar-denominated obligations.

Remember that the rating agency definitions don't say anything about accounting for the value of the money used to repay a debt, just whether the debt will be repaid. Thus, the real risk is not default. Instead the real risks are high inflation (from printing money) and weak economic growth.

Long-Term Implications The long-term implications of the downgrade might be quite different than the short-term ones. For example, the downgrade is likely to lead to an increase in the already-existing trend of diversification away from the U.S. dollar as a reserve currency. For example, in 1999, the dollar represented about 70 percent of foreign currency reserves. Today, that figure is about 60 percent. After Japan lost its AAA rating, its share of global foreign currency reserves was cut in half in just four years, from about 6 percent to around 3 percent. Also keep in mind that foreign investors have supplied 30-40 percent of our non-financial credit creation over the past few years.

An increase in the pace of diversification away from the dollar would likely be an economic drag, as domestic savings would have to rise to pick up the slack. And the cost of Treasury debt could also increase, making financing the deficit more difficult.

Equity Market Regarding equities, the problem for the markets is that the downgrade increased an already high level of uncertainty about the prospects for global economic growth, not just U.S. growth. That explains why the market experienced such a sharp sell-off yesterday -- investors hate uncertainty and increase the risk premium they demand to accept it when uncertainty levels rise. Given that we must address the problem of the deficit, consumers surely now expect significant spending cuts in federal spending and/or large tax increases. That could easily undermine already weak consumer confidence, which in turn would likely lead to a reduction of spending on nonessentials.

Keep in mind that consumer spending makes up about 70 percent of the economy. Thus, it's possible that with all the headwinds and uncertainty we face, the downgrade might just be the straw that breaks camel's back for investors, with selling begetting more selling. Thus, it's possible that we could experience another sharp downward move. Unfortunately, history doesn't provide much of a guide. Some nations' stock markets have quickly shrugged off downgrades in the past, while others haven't.

• Next: What Are the Alternatives?

Japan Japanese yields are even lower than ours, and Japan's balance sheet is considerably worse (with a debt-to-GDP ratio of about 200 percent).

Italy The Italian debt-to-GDP ratio is much higher than ours (about 120 percent), and it has budget problems of its own.

In addition the U.S. is better positioned than either Japan or Italy to grow their way out of the problem.

The U.K. is another potential choice, but doesn't seem to be a much better one. First, its market is a small fraction of the Treasury market (about one-sixth). Second, its debt-to-GDP ratio is currently a bit higher than the U.S.'s, though it has taken tough actions to address the problem. Emerging market debt isn't a credible alternative either -- as the bond markets are much smaller, currencies aren't fully convertible in many cases and political and legal institutions aren't as stable.

Whenever there's a crisis, the focus seems to be only on the bad news, with positives getting "lost in the shuffle." On Friday, I highlighted a few of the positives we're seeing in the economy. Given the bad news we've been reading about in the past few days, it's important to see some of the positive changes during this time as well.

Oil Prices Since August 3, oil prices have continued to fall, dropping from $87 a barrel to just over $81 at the close of business Monday. Drops in oil prices have similar stimulative effects as tax cuts.

Interest Rates Interest rates have continued to fall as well. On Monday, the yield on the 10-year Treasury hit its lowest point for the year. At the start of the year, the yield was 3.36 percent. On Monday, it was at 2.40 percent. That impacts the costs of many other forms of borrowing, including mortgages, which have also fallen in the past week. According to Bankrate.com, a 15-year fixed mortgage was down to 3.50 percent on Monday from 3.58 percent the previous week. Also, a 30-year mortgage was down to 4.33 percent from 4.47 percent the week before. That makes housing more affordable and will allow those with equity to refinance at lower rates. Also the cost of borrowing for corporations has fallen. And the same is true for municipal bonds. Lower rates, while bad for investors, is good for borrowers.

What You Should Do The advice remains the same. Stick to your well-designed plan, as it should have anticipated that frequent crises and bear markets are the norm. You should be well prepared. If your plan doesn't seem prepared for this type of crisis (or you simply don't have a plan), talk to your trusted advisor and see what changes should be made. There's no guarantee we will have a happy ending to this one. If you make changes, you may have to make other changes such as altering your goals, work longer, spend less, and so on.

More on MoneyWatch:
How Markets Have Responded to Past Sovereign Downgrades Don't Panic: Stock Market Crises Are Normal Why the Market Is Behaving Badly Stocks Plunge: Why It's Too Late to Sell
Three ways I can help you become a wiser investor:

• Follow me on Twitter: http://twitter.com/larryswedroe.
• Read my latest book The Quest for Alpha.
• Download the podcast of my radio show via Buckingham Asset Management's iTunes page.