Last April, when Standard and Poor’s downgraded its outlook on the long-term sovereign debt of the United States to “negative”, stocks closed down a bit more than 1%. The Dow Jones Industrial Average fell about 140 points (it fell 247 points at one point during the session). Both the S&P 500 and NASDAQ fell. The CBOE Volatility Index, VIX, widely considered the world’s premier barometer of investor sentiment and market volatility, rose just about 11% to nearly 17, after trading well above 18 earlier in the session.
However, it might be wrong to read now too much into the market reaction to S&P’s decision to downgrade the outlook for U.S. long-term debt as it came during a week marked by both the Passover and Easter holidays. As a result, many of the most active market participants were on vacation, leaving trading desks thinly staffed. During a fully staffed season, like now, the market could have fallen more, some experts say. On top of that, as of Friday, the U.S. stock market was coming off its worst week since the financial crisis, knocked down by worries of an economic slowdown and the possible contagion of Europe’s sovereign-debt crisis.
David Beers, head of sovereign ratings at S&P, and the top official behind the unprecedented, if not unexpected, decision to downgrade the United States’ prized triple-A credit rating, has said it was his company’s duty to make such a hard and controversial call. The unfortunate part is that this decision could eventually raise borrowing costs for federal and state governments, companies and consumers. While banks and broker-dealers wouldn’t likely suffer any immediate ratings downgrades, S&P had already announced two weeks ago that they would downgrade the debt of Fannie Mae, Freddie Mac, the ‘AAA’ rated Federal Home Loan Banks, and the ‘AAA’ rated Federal Farm Credit System Banks to correspond with the U.S. sovereign rating; they would also lower the ratings on ‘AAA’ rated U.S. insurance groups, as per their criteria that correlates insurers’ and sovereigns’ ratings.
Despite these negative consequences, I am inclined not to kill the messenger and see S&P’s decision in a positive light as it should serve as an effective wake-up call to get Washington’s warring players to the negotiating table again. In the past, S&P’s decision to put the UK’s AAA-rating on negative outlook in May 2009 fueled a debate on the need for significant fiscal tightening, and the tough decisions taken by the new coalition government were eventually rewarded by S&P with the UK’s outlook being revised back up to stable in October last year. By entering the debate in this way and at this time, S&P is serving a useful public service by putting all parties on notice that words and actions in the political debate have consequences that will impact 300 million Americas.
We cannot deny the significant psychological impact of S&P’s decision on the markets and the view of foreign governments and investors of the U.S. economy. However, I expect Monday’ stock plunge to be a short-term event that will lose steam quickly. In fact, investors can be tempted to use it as reason to snatch value plays, as there would have not been a fundamental change from where we were last Friday. At the end of the day, S&P’s main theme, that U.S. finances are in bad shape, is not news to investors and traders; for instance, Pimco, the world’s largest bond fund, had stepped away from US government debt back in March; in addition, savvy money managers had already positioned themselves for a potential rating downgrade.
I agree with experts who sustain that the downgrade will not lead to sharp rises of lending rates to the corporate sector or households in the U.S., as Fitch and Moody’s still maintain their top rating for U.S. debt. Also, a sudden sell off of U.S. Treasury instruments looks unlikely, as there are still not many safe assets to replace them. Once the dust settles, attention will turn back to the economic fundamentals. Disregarding the S&P downgrade comes with high risk for the U.S. economy, particularly if Washington prioritizes electoral concerns over the long-term health of this great nation, the United States of America.
Edgar Perez is the author of The Speed Traders.