The Truth about the Downgrade and the Downturn

After a period of growth and semi-stability where many hoped that the worst of the market volatility was behind us, last month we experienced dramatic downturns not seen since the dark days of 2008. Some will blame the Dow’s freefall on Standard & Poor’s decision to downgrade U.S. Government debt from its AAA to a lesser AA+ credit rating. (See the “S&P Downgrades the U.S.: Five Things” for details.)

While the downgrade is unprecedented, in my view, it is not responsible for the profound market volatility we’re experiencing. More likely, the steep decline reflects the market’s broader frustration with the difficulty our elected officials had striking a debt ceiling compromise and the fact that Washington’s solution is a temporary fix. Congress and the President ultimately agreed to a budget cut of $2.1 trillion, half of the figure initially debated.

Standard & Poor’s has grabbed all the headlines, but it’s important to note that the other two major credit agencies, Moody’s and Fitch, elected not to downgrade U.S Treasuries. Although sticking with their top rating of Aaa, Moody's Investors Service did assign a negative outlook on United States government bonds on August 2. The firm noted that it could take “further action if: (1) there is a weakening in fiscal discipline in the coming year; (2) further fiscal consolidation measures are not adopted in 2013; (3) the economic outlook deteriorates significantly; or (4) there is an appreciable rise in the US government's funding costs over and above what is currently expected.”

Regardless of being on a kind of watch list, U.S. debt still remains among the world's safest investments. In fact, we’ve seen a rally in the Treasury market with the traditional “flight to quality” that occurs when we experience dramatic market downturns. It’s also worth noting that the downgrade to AA+ does not apply to short-term Treasury securities. Accordingly, money market funds, which generally hold a lot of short-term Treasury securities, should be unaffected by the downgrade. There may be long-term negatives, however. China and other foreign countries could demand a higher interest rate to hold U.S. debt. Additionally, consumers could face higher rates for mortgages, car loans, and student loans. Stay tuned.