Implications of the S&P Downgrade

Last Updated Aug 9, 2011 6:19 AM EDT

On Monday, we took a look at what has happened historically to the bond market after a nation has had its debt downgraded. Early signs looked great for Treasuries, as investors poured money in, causing prices to rise and yields to fall. Today, we'll take a deeper look at the implications this may have for both the stock and bond markets.

Before launching into the implications, there are a few important reminders about the downgrade itself. First, Standard & Poor's sent a message that our problem (unlike Greece, which has an economic problem) is simply one of having the political will to take the actions needed to change the trajectory of our debt-to-GDP ratio. S&P did affirm its A1+ short-term rating and removed both the short-term and long-term rating from CreditWatch negative.

Also, it's important to note that the other two rating agencies -- Moody's Investors Service and Fitch Ratings -- affirmed their AAA credit ratings on August 2, the day President Barack Obama signed the bill that ended the debt-ceiling impasse. However, Moody's and Fitch did say that downgrades were possible if lawmakers fail to enact debt reduction measures and the economy weakens.

This Isn't S&P's Fault I've heard some people trying to place the blame on S&P. Blaming S&P for the downgrade doesn't make sense. S&P had given clear warnings months ago by placing Treasury debt on negative warning. And the world already knew we didn't deserve a AAA rating, because we had failed to take the steps needed to avoid it. Credit-default swap (CDS) spreads were already indicating this -- the capital markets are always ahead of the rating agencies, which are a lagging indicator.

Another great example illustrating that Treasury debt had lost its special position involves the one and only Warren Buffett. As long ago as March 2010, Berkshire Hathaway's debt traded at a lower yield than the similar maturity Treasury, meaning the market viewed Berkshire Hathaway debt as safer than U.S. government debt. At the same time, Moody's issued a warning that the U.S. was moving "substantially" closer to losing its AAA rating.

The deal to avoid default didn't deliver significant immediate cuts, and Congress's ability to deliver on future cuts has no credibility with anyone. To prevent the debt-to-GDP ratio from continuing its upward trend, about $4 trillion in real cuts was needed. We didn't get anywhere near that. The bottom line is that the downgrade is a result of the problem, not the cause.

Photo courtesy of wwarby on Flickr.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.