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US Debt Downgrade: What Matters and Why?


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

  • If the market opens in the hole (read: gaps lower Monday morning), the first fade higher will likely be the easy trade.

  • I would have more confidence that the rally would have legs if I wasn't hearing similar views from every direction.

  • The rating-agencies missed the first phase of the financial crisis. Now, they're picking a fight with the biggest guys on the block (Italy also launched an investigation last week).

  • That's a different conversation than whether the U.S.A. should have been downgraded. The answer is "yes," and it should have been done long ago.

  • Heck, if an Emmy Award winning financial media platform saw the financial crisis coming, the folks in Washington (and Wall Street) should have as well.

  • That too is a different conversation than whether or not this is the second side of the financial storm.

  • The Federal Reserve has been quick to assure investors, saying "Move along folks, there's nothing to see here" as a matter of course. They've already assured banks that they would not have to increase capital that was backed by government obligations.

  • Indeed, my biggest concern wasn't the downgrade itself, it was how the White House reacted.

  • The other variable is the investment charters that prohibit funds from investing in anything other than AAA-rated securities.

  • We've already heard widespread rumblings indicating said funds won't be forced to sell those securities (which would trigger higher rates in the near-term), given Fitch and Moody's have yet to punt..

  • I do sense that we'll retest the lows of March 2009 but A) that may not happen until 2013 (if it happens at all) and B) there will be pockets of false hope and empty promises littered along the way... and one of those may arrive soon.

  • It's called a process of price discovery, not a point of price discovery. Don't try to be The Greatest American Hero, just stay in the game as there will be fewer and newer players when this dust is finally allowed to settle.

  • Finally, due to market turmoil, I encourage you to take a free trial to our real-time Buzz & Banter where some of the smartest people I know provide their thoughts and analysis and guide readers through the markets each day. Any questions, please email us.


Twitter: @todd_harrison

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No positions in stocks mentioned.
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