America’s Downgrade: What Does It Mean?

The rumors and forecasts of an imminent downgrade turned out to be accurate as Standard & Poors downgraded the United State’s AAA credit rating one level to AA+ on August 5th. Already nervous investors from the debt ceiling crisis panicked, dumping stocks across the board. The selling sent the benchmark S&P 500 plunging from a near term high of 1347 to 1101. Fear-gripped traders rocketed the VIX index to near 50, levels not seen since the 2008 financial meltdown. Let’s take a closer look at what the downgrade actually is and what it may mean for all of us.

Standard & Poors has maintained a AAA credit rating on the United States since 1941. Only a handful of other nations, namely Canada, Germany, France, and the United Kingdom, have the honor of the AAA top S&P credit rating. The credit rating agency cut the United State’s debt rating to AA+ due to outstanding debt and no clear plan to alleviate the debt. Remember, the United States has an astounding $14.3 trillion in debt and has projected deficits for years in the future.

Even worse for the United States, Standard & Poors stated that it has a negative outlook for the future on the debt. We all know how adverse a negative outlook can be on a corporation, and the same holds true for countries. The outlook can actually be more damaging than the reality of the ratings.

Citing the political turmoil in Washington over raising the debt ceiling, Standard & Poors stated in their Global Credit Portal, “The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.”

Slamming the political climate, the rating agency went on to state, “More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.” By way of additional explanation, S&P went on to state, “Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon.”

Although the economic picture is dire, Standard & Poors made it clear that their downgrade has political roots. This is good news as it’s certainly easier to compromise politically than to revamp an economic system. A bright signal emerged from the most recent Treasury Auction. The benchmark 10 year note dropped to 2.34%, the lowest level in 10 months. This indicates that many still see the United States as a safe place to invest despite the downgrade. In addition, short term debt remains rated at A-1+, the highest possible level.

Other than the knee jerk reaction in equities, what can we expect going forward? Long term effects of the downgrade may include higher interest rates across the board, but the money market and short term debt is unlikely to feel an impact.

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