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What the U.S. debt-rating cut may mean for markets

August 6, 2011 |  6:51 pm

The decision by credit-rating firm Standard & Poor’s late Friday to cut America’s rating to AA+ from AAA has stoked fears of more turmoil in financial markets, which already are on edge over the weakening global economy.

Here’s a look at what S&P’s move means, and the potential effects on interest rates and across the financial markets:

What does the new rating say about the U.S. government's creditworthiness?

It’s really a subtle shift. S&P says a country rated AA has “a very strong capacity to meet its financial commitments,” as opposed to the "extremely strong" capacity of an AAA-rated nation.

The bottom line is that an AA-rated country’s creditworthiness differs from an AAA-rated country “only to a small degree,” S&P says.

What’s more, by adding a “+” to the U.S. rating S&P signals more confidence in the country’s finances than if the rating were AA alone.

Then why is the downgrade such a big deal?

Because it’s a watershed moment many people never thought they’d see -- the credit of the most powerful country on Earth is being questioned, even if the element of doubt is minor.

The drop in the rate puts the U.S. in the same general camp as other AA-rated countries including China and Japan (both rated AA-), along with Spain, Kuwait and Slovenia (all rated AA).

Treas Do other credit-rating firms agree with S&P?

No. Its two main rivals, Moody’s Investors Service and Fitch Ratings, last week said they were keeping their U.S. ratings at AAA for now. But both warned that a downgrade could occur if the U.S. failed to rein-in growth of its debt load, now $14.3 trillion.

How much does this downgrade have to do with Congress’ recent fight over the federal debt ceiling?

That was one of the key elements S&P cited, saying the battle over the debt ceiling showed that U.S. policymaking was becoming “less stable, less effective and less predictable than what we previously believed.”

In effect, S&P is treating the U.S. like a much smaller country prone to more political risk than would be expected of a great power.

Will S&P’s new rating cause some big investors to sell their Treasury bonds, driving interest rates up?

That’s possible. But analysts say relatively few investors would be forced to sell simply because the U.S. rating now is AA+ rather than AAA.

U.S. banking regulators on Friday said they would not require commercial banks to build up more capital to compensate for the lower rating on the Treasury securities they now hold as a cushion.

Also, although S&P cut its long-term-debt rating for the U.S., it maintained its separate rating on short-term debt at the highest grade. That means the $2.6-trillion money-market mutual fund industry wouldn’t have any reason to bail out of short-term Treasury issues.

Foreign investors are a bigger question mark. Many, including China, the single largest foreign holder of U.S Treasuries (it owns $1.2-trillion worth), have expressed growing uneasiness about soaring U.S. debt levels.

If investors dump Treasuries, where would the money go?

They don’t have a lot of options if they want to keep their money in something relatively safe.

The bond markets of other countries still rated AAA -- including Germany, Canada, France, Finland and Australia -- are far smaller than the U.S. debt market. The appeal of Treasuries in part is their great liquidity, meaning it's easy for investors to instantly buy or sell bonds.

What’s more, Europe has its own worries: The continent’s government-debt crisis has worsened in recent weeks, with investors now fearing that Spain and Italy could be forced to seek European Union bailouts, following the paths of Greece, Ireland and Portugal over the last 15 months.

Some investors are likely to run to gold, another classic haven. Gold has been streaking this year, rising 16% year-to-date through Friday, to $1,648.80 an ounce.

Haven’t Treasury interest rates been falling lately, anyway?

Yes. Investors have been pouring cash into Treasury securities since mid-April, driving interest rates down, as global economic growth has faded. The rate on the 10-year Treasury note, a benchmark for mortgage rates and other long-term interest rates, fell as low as 2.40% last week from 3.59% in mid-April.

Because worries about the economy have only worsened in recent weeks, many analysts believe that any jump in Treasury rates related to S&P’s downgrade could quickly bring a torrent of buyers into the market, happy to snag higher yields.

“The fundamentals of U.S. and global growth are weakening, and that’s a fertile time to be in Treasuries” as a haven, said William O’Donnell,  head of Treasury-bond strategy at RBS Securities.

Mtgrate If Treasury rates do rise, what would the effect be on other interest rates?

Mortgage rates almost surely would rise from what are now near-record-low levels. The average 30-year home loan rate (charted at right) was 4.39% last week, according to mortgage giant Freddie Mac.

Likewise, other rates that key off Treasury rates -- foreign bond and corporate bond yields, for example -- could rise.

Many consumer loan rates, however, are pegged to banks’ prime rate. That rate, in turn, is tied to the Federal Reserve’s benchmark short-term rate, which remains near zero. And Fed policymakers, who will meet Tuesday, are highly unlikely to be raising their rate anytime soon given the struggling economy.

Interest rates that some state and local governments pay to borrow via municipal bonds could rise even if Treasury rates don’t. That’s because S&P is expected to follow its U.S. downgrade with cuts in ratings of some muni bond issuers, particularly states that get significant amounts of federal funding.

What about the stock market?

With share prices already in steep declines worldwide over the last week on concerns about the global economy, analysts worry that S&P’s move will give investors another excuse to sell riskier securities such as stocks. The Dow Jones industrial average plunged 5.8% last week, its worst weekly decline since the depths of the recession in March 2009.

Ironically, the U.S. downgrade “is more likely to lead to a sell-off in risk assets than a stampede out of Treasuries,” said Mohamed El-Erian, head of money management firm Pimco in Newport Beach.

-- Tom Petruno

RELATED:

S&P downgrades U.S. credit rating

Wall Street sees no reason to hit the panic button

Memories of the stock market crash leave investors on edge

Moody's and Fitch keep U.S. triple-A credit rating, but say outlook is negative

Photo: The Treasury building in Washington. Credit: Andrew Harrer / Bloomberg News

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