On August 5th of last year ratings agency Standard & Poor's downgraded the credit rating of the U.S. Federal Government from AAA to AA+. Though widely telegraphed the news sent stocks tumbling with the benchmark S&P 500 (^GSPC) index dropping 6%.
Despite vows at the time to change their profligate ways, the U.S. has, if anything, gotten even more fiscally reckless in the nearly 11 months since the downgrade, raising the questions as to whether or not the existing AA+ rating is at risk. Robert Prechter of Elliott Wave International says such another downgrade is "pretty likely, eventually" but regards ratings changes as the least of America's problems.
At the heart of Prechter's concern is the U.S. borrowing costs. Despite the hand-wringing of last August, bond yields have actually dropped since then. At time of S&P's downgrade the yield on the 10-year treasury (^TNX) was 2.94%. Today the rate stands at 1.58%.
Regardless of what S&P says about the U.S. credit rating, investors still regard our debt as a safe haven. But Prechter thinks that's about to change. "After 31 years the bond market may be ending a very long term uptrend and getting ready to turn down," he says, "that means higher rates."Once borrowing costs go higher the Federal Reserve will have few options left for fighting it's real problem: deflation. Prechter notes the current economic environment includes historically low rates, a 40% decline in real estate, a 40% drop in commodities, low money velocity and last month's drop in CPI. "These things are a surprise to most people," says Prechter "but deflation explains them all."
Deflation is a lack of demand for goods or services at any price. The Fed has a mandate to control inflation and Volcker showed the world how to do it by strangling the supply of money. Deflation has no known cure. The Fed can, and has, dropped rates to zero yet no one seems to have the confidence to borrow money. Economists love to fight inflation, what keeps them awake is the notion of demand dropping no matter what the price.
Prechter's sees America's "free ride" in terms of borrowing costs coming to an end as global investors come to realize the U.S. is no different than any other print-and-spend nation. The Fed sets the Fed Funds rate but the market decides how much it costs the U.S. to borrow money. When the U.S. starts getting punished for its profligate ways austerity will be thrust upon it at the time the Fed would most want the chance to "stimulate."
Personal financial planning in a deflationary environment is simple. Sell everything and hoard money. "Cash is becoming more valuable," is how Prechter puts it. "That's what you want to hold on to."
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