Last Monday the markets went ballistic when ratings agency S&P downgraded its U.S. credit rating outlook from “stable” to “negative.” Since S&P is the first among the top three ratings agency hotshots to lower its outlook, market junkies reacted violently.
The Dow Jones Industrial Average, an indicator of U.S. stock market prices, dropped by 1.14% to 12,201.59–its biggest decline in a month! Meanwhile, the dollar pairs also reacted strongly to the news as USD/JPY fell to an intraday low of 82.20. And here we thought that Cyclopip banging his head on a rock is already the most awesome form of panic!
Like the hot economic detective that I am, I took a closer look at the report and saw that S&P made the downgrade for one major reason. Apparently, the agency was fed up with waiting for Democratic and Republican lawmakers to address the country’s deficit problems.
Though they’ve already had debates on the issue, many of the agreements have only focused on short-term spending cuts and not long-term structural changes that could elevate the U.S. economy to the level of its other AAA rated homies.
Perhaps the outlook downgrade may just be the catalyst needed to get U.S. politicians to get along and play nice. With total deficit just a few billion away from the $14.294 trillion cap (Yes, believe it or not, there’s actually a limit to how much debt the U.S. can have), these politicians are playing with fire. In fact, if they don’t get their act together fast, Uncle Sam may default on its debt as soon as July 8!
This has shaken investors, some of whom are thinking that a negative outlook may lead to an actual credit rating downgrade!
This is pretty much unknown territory for the U.S., as Treasuries have NEVER lost their AAA-rating. Treasuries and an AAA-rating go together like white on rice, like Apple and Steve Jobs, like Kobe and Shaq (okay maybe not that last one). But what would happen if it did get downgraded?
A credit downgrade would cause Treasury interest rates to rise, as investors would want additional returns for the extra risk of holding a less credit-worthy asset. This would have a trickle down effect of raising the cost of credit throughout the economy, as Treasury rates are normally used as a benchmark for lending rates. It will then make business loans more expensive, motivating businesses to move their funds to other countries. Imagine its impact on economic recovery!
It would also be interesting to see how this affects the beloved dollar. For the longest time, the dollar has been perceived as the ultimate safe haven. After all, it was the world’s reserve currency!
But a credit downgrade just might change all that.
Lower credit ratings mean higher chances of default, which would dent the dollar’s safe-haven reputation. In addition, giant economies like China and Japan, who have massive currency reserves, would have to re-evaluate their exposure to their dollar holdings. I mean, what happens if these countries decide that holding dollars is just way too risky? We could see the ol’ Greenback fall apart faster than Charlie Sheen’s career!
In the meantime though, let’s hope that last Monday’s outlook downgrade serves as a big wake-up call to our buddies over in Washington. More importantly, let’s hope they don’t resort to some band-aid solution and instead, come up with some plans to right the ship for the long haul.