U.S. Gets the Downgrade It Deserves

Jeff Macke

S&P downgraded the U.S. credit rating from AAA to AA+ on Friday evening. The move was controversial, unprecedented and newsworthy to the point that it made the cover of even the non-financial press. The headline on the cover of today's NY Post blares "Debt Bomb."

The Financial Times is calling the downgrade "a contentious and historic move that highlights the weakened fiscal stature of the world's most powerful country." The key word there is "highlights." Which is humiliating but hard to argue. Make no mistake: The U.S. more than earned this downgrade. The nation is absurdly debt-laden and shows absolutely no signs of stopping.

The most galling aspect of the downgrade is that the final straw was the debacle of a debt-ceiling debate. Yesterday I said DC's lugubrious drama and resulting fake solution made up the most financially damaging fake crisis since LBJ's "Gulf of Tonkin" incident escalated the Vietnam War. S&P was nice enough to more or less confirm the point in comments made to the Financial Times. "The political discourse has diminished the credit standing of the United States," said John Chambers, the man who essentially made the final call.

Increased government spending at this point was a foregone conclusion, no matter what either side was saying. The country is in a recession (at least as far as I'm concerned; the National Bureau of Economic Research will make the official call in about six months, but why wait?). Stimulus is the only solution we know for a slow economy and was obviously what Washington was going to do. The problem for financial markets is less the spending itself and more the fact that the spending isn't actually stimulative at all.

Our GDP is under 2%, our unemployment rate is over 9% and both numbers are likely much worse than advertised. Our nation turned our desperate eyes to Washington, looking for grownups who could give us hope. Austerity, stimulus, a jobs program, corporate hiring breaks … just a different strategy of some sort. What we got was a batch of simpletons and whiners working the mic like bad professional wrestlers for two weeks before giving us a faux solution at the 11th hour. It was actually worse than professional wrestling; at least The Rock would have given us better rants.

During the Great Depression, FDR had a policy of trying almost anything and seeing what worked. If a plan seemed to stimulate, he kept it. If it didn't, he scrapped the idea and moved on to something else. Nothing except WWII snapped us out of the Depression, but there's a reason Roosevelt kept getting elected; at least the man didn't keep pouring more resources into solutions which obviously didn't work.

Breakout has been telling you the downgrade was a done deal for more than a week . We've been telling you how traders have been pricing in a downgrade. We've called it looming. We reported on the stock market chattering about this downgrade yesterday. I laid out the winners and losers on the fake deal last Monday.

What I'm saying is the downgrade was both deserved and anticipated. Looking ahead, here's what you need to watch and know:

  • Stock Market Reaction: From where I'm sitting, stocks have been pricing this in for a week and half. It's no surprise the selling started at roughly the same time as the ratings agencies started threatening the downgrade. The chatter of a downgrade on Friday was met with a brief, albeit frightening, sell-off of a few hundred points. That seems the most likely response here. Another "Black Monday" shouldn't result from S&P stating the obvious.
  • Debt Market Reaction: This is where the potential problem lies. All debt is priced based off the "risk free" rate paid by the U.S. government. Our government paid the lowest rates; everyone else from municipalities to corporations paid a higher rate based off how much riskier they were than the U.S. as a whole. Now that the US is deemed less than risk free, it's unclear how much higher the cost of money will be for everyone else. In other words, no one knows for sure how big the knock-on effect will be.

Note that the yield on corporate debt from blue chip to junk is nearly as low as it's ever been. Also note that Treasuries are paying historically low rates; in fact, so low that buying the 2-year actually costs you money if you include even modest inflation in the calculation.

Also remember that no rational person on earth was unaware that the state of the United States financial system was not as pristine as a AAA rating implies. The question wasn't whether or not a downgrade was deserved but if the ratings agencies had the guts to cut the AAA for the first time in history. S&P walked the talk, Moody's folded like a cheap tent in the wind. Make of it what you will, but you can't say we couldn't see this coming. There's cause to be concerned about rates across the board moving higher, but there's room for it to happen without triggering an economic crisis.

The Federal Reserve has already announced it will continue to accept Treasuries as collateral. In English, this means the Fed isn't going to force a margin call. That's good news.

Your bottom line is that you can weep for what the U.S. has become but you don't need to flee from Treasuries or blue chip debt based on the actions of Standard & Poor's. The agency did the right thing and deserves a huge amount of credit for having done so. In effect, this move just means S&P gets the very same credit they just took from the United States.

It's a butt-kicking our country richly deserves.

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