US Debt Downgrade: What Matters and Why?

By Todd Harrison  AUG 06, 2011 3:45 PM

A historic event interrupts our weekend.

 


After a contentious debate with The White House, Standard & Poor’s, a unit of McGraw-Hill (MHP), cut the long-term US Government credit rating from AAA to AA-plus (and left it on negative watch for further downgrades) for the first time in history.

"The downgrade reflects our opinion that the fiscal consolidation plan -- which Congress and the Administration recently agreed to -- falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics," S&P said in a statement.

This shouldn’t be a shocker to the Minyanville community.

As discussed a few weeks ago in the ‘Ville and on Bloomberg, the recent decline in the market had been pricing in this very event. We opined that if the market broke S&P 1250, it “worked” to S&P 1130 on a technical basis. Now that the big bad event is out of the way, we’re left to wonder what’s next.

To quote a passage from last week:

“The government won’t default; the resulting financial fury would make Lehman Brothers look like a pimple on an elephant’s ass. No, they’ll arrived at an 11th-hour rescue that appeased both parties, avoids the worst-case scenario, and perhaps even makes politicians look magnanimous for their sacrifices in the summer heat.

Unfortunately, that’s not where this story will end. In some ways, it’s where it begins. The US will lose its vaunted AAA rating, in my view, which is an outcome already signaled by the rating agencies. The venomous political process, coupled with the structural debt dilemma, warrants such a move and the ramifications will manifest for mainstream America.

How? Two words: higher rates. The consumer, many of whom are over-extended on their credit or underwater on their homes, will be forced to pay more interest on their credit cards, car loans, gas prices, and mortgages. It won’t be a sudden spike -- it will be a gradual bleed -- but those can be just as debilitating.

Conventional wisdom dictates that the market will enjoy a relief rally on the heels of the debt ceiling agreement despite the negative longer-term implications (slower growth). That’s what everyone is banking on, for obvious reasons; the alternative is pretty scary indeed. (See: Will The Fed’s Last Bullet be Pointed Inward?)

Should that scenario unfold -- and I sense the bulls give it a try as long as Europe holds together -- enjoy it for what it’s worth and remember not to overstay your welcome. You always want to leave a party while everyone else is having a good time.

Random Thoughts

R.P.

Twitter: @todd_harrison

No positions in stocks mentioned.

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

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