Much has been said about the Friday night downgrade by Standard & Poor’s of the US sovereign credit rating from AAA to AA+ and the impact this will have on the markets. While this action is significant, it is important to remember what a credit rating is and what it is not. According to Standard and Poor’s, credit ratings are “opinions about relative credit risk”. In this regard, we have a split opinion by the three major credit rating agencies and S&P is the only one to downgrade the US from AAA or the highest ratings equivalent. 

While the downgrade covers all US obligations, the market impact should be most visible in the Treasury bond market. The major fear is that the US will witness an increase in borrowing costs which translates into higher yields. This will come in the form of either a selloff in Treasury bonds bringing prices down thus increasing the yield on existing bonds or through lackluster demand the next time the US treasury auctions new bonds forcing it to pay a higher interest rate. That is the theory, however in practice we believe that there will be little or no material impact on the Treasury bond markets come Monday.

While S&P’s, and other rating agencies’, opinion are of tangible and practical value to most investors, the value of these ratings decreases with 1) the size and transparency of the issuer, 2) the level of complexity of the particular instrument being rated, and 3) the availability of an existing market in an identical security by the same issuer. Furthermore, when it comes to US treasuries, or any other instrument, we posit that ratings are IRRELEVENT to those who have no choice but to buy them.

Credit ratings, by definition, are an opinion on an issuer’s willingness and ability to pay its obligations. When a bond is issued and starts trading, the market becomes the best judge of an issuer’s ability and willingness to pay and a bond’s yield becomes the best measure of this. However, when it comes to fixed income securities in general, and sovereign bonds (such as Treasury bonds) in particular, the market price is also a vote on the value of the currency that the bond is denominated in. (A bond’s liquidity is also reflected in the price as well).

The reason for this long introduction is to lay out the reason why nothing practically has changed. The US ability to pay its obligations should never be in question because its obligations are denominated in US dollars and whenever those obligations come due the US treasury can print as many dollars as needed if there wasn’t enough on hand. However, this downgrade has a bit to do with the US willingness to pay its obligations as the US came very close during the debt ceiling debate to defaulting on its obligations by simply opting not to take the necessary steps to doing so.  However this downgrade came after this has been averted and remedied.

It is because of the US ability to pay its obligations, US treasuries, and in turn the US dollar, have always been the premiere safe haven of choice for all investors – particularly those who have US dollars to invest. This category includes all investors within the United States, but also all of the US trade partners who have a trade surplus with the United States such as China and the oil producing Gulf states. Hence, if you need safety of principal and you have a gigantic amount of US dollars to invest, then in reality you have no other market that is as big, safe and liquid as the US Treasury bond market.

Impact on financial markets and economy:

While we established above that there should be little or no impact on the Treasury bond market, the impact of the S&P downgrade on US stocks and global financial markets is less clear. In a world where the US economy is slowing down and many European nations are battling prospects of insolvency, it is normal to expect a trend by global investors to reduce risk. In our view, emerging markets will bear the brunt of this global de-risking as emerging markets by definition are riskier than their more developed counterparts.  In Europe, it looks more likely that we will see a coordinated plan of defense by the European Central Bank and the European Union that extends a safety net to the markets similar to what we have seen with Greece and Ireland.  However, in a global state of de-risking it is not inconceivable that US treasuries and the US dollar will be the beneficiaries of fund flows out of the Euro region.

As for US stocks, we think that the economic slowdown and the fairly modest job growth that we have experienced during the first seven months of 2011 are the main factors weighing in on equities going forward. In this regard, the prospects of a new round of monetary easing by the Federal Reserve, similar to QE2, becomes more likely the more weak or disappointing economic reports we see. However, now that S&P actually went ahead and downgraded the US credit rating we believe that there is less of an incentive for the US government to reduce fiscal spending to maintain a AAA rating that has been already lost. That along with the fact that we are entering into the 2012 election cycle, we believe that a government stimulus targeted towards job creation is more likely as it will be hard to envision, today, that the current administration or even many Republicans in Congress would be re-elected with an unemployment rate north of 9%. This being said, equities should remain volatile for the duration of the third quarter, and particularly this month, until new stimulus is announced and is implemented.