The downgrade of the U.S. credit rating from triple-A to AA-plus by the credit rating agency Standard & Poor's may not sound like a big deal, but it marks the first time since 1941 that the U.S. government hasn't carried the highest rating at any of the major ratings agencies, and it hit global financial markets like a bombshell.
Coming at a time of serious uncertainty and pessimism about the economy, the downgrade could have major consequences for investors, borrowers and the American economy.
Short-term pain for stock market
Although a major, long-term collapse in stock market values is unlikely to result from the downgrade, individual investors may panic and cause a short-term stock sell-off, says Sam Wardwell, investment strategist for Pioneer Investments in Boston. On the first day of trading after the downgrade, the Dow Jones Industrial Average fell by more than 634 points.
"In the short term, there might be some retail investors who panic, but professional investors, I think, by and large won't panic because the ratings agencies … aren't really telling us anything we don't already know," Wardwell says.
"The impact on the economy, if you think about it in terms of corporate profits and therefore the appropriate price-earnings ratio for the S&P 500 (index), it's not a very strong linkage at all. But you can never tell what the panicky retail investor who listens to too much TV and talk radio will do," he says.
Jim Nadler, president of the New York-based Kroll Bond Rating Agency in New York, says the long-term impact of S&P's downgrade on stocks is not as important as more fundamental factors such as corporate earnings, gross domestic product, or GDP, growth and consumer demand.
Even so, the S&P decision could have a long-term impact on stocks if it hampers the so-called repo markets. In the repo market, large financial institutions take out overnight loans from one another to meet their short-term funding needs, customarily putting up U.S. Treasuries as collateral. If those Treasuries are seen as riskier investments going forward, banks will likely have to put up more of them to get the same-size loan, increasing their borrowing costs and reducing profits, Nadler says.
Another possible way the S&P downgrade could depress your portfolio is by inducing a wave of "forced selling," Nadler says. Many stock and bond funds as well as big institutional investors such as insurance companies have guidelines requiring them to hold a certain percentage of assets graded by ratings agencies as triple-A. Because Treasuries are now graded at less than triple-A by one ratings agency, it's possible that these guidelines might force these funds to sell Treasuries to meet their quality requirements. A big sell-off could lower the price of Treasuries, reducing the value of Treasury holdings by other firms and triggering a severe market reaction.
Still, Nadler says that's not likely to happen. He says few of the contracts and standards in the industry require a triple-A rating from S&P itself. As long as the other two major ratings agencies, Moody's and Fitch, don't follow suit with a debt downgrade, forced selling of Treasuries shouldn't happen at such a large scale to have a catastrophic effect on global markets, Nadler says.
Treasuries still safe
Despite the downgrade, Treasuries are still functioning as a safe haven for global investors. That's because despite its deficit and political shortcomings, the U.S. is still perceived as less risky than most other industrialized countries, especially those weighed down by more serious debt troubles, such as Spain and Italy.
That special status has kept U.S. Treasury values high and interest rates low throughout the recent series of high-profile political crises culminating in the debt-ceiling debate, Nadler says. He compares it to the old joke about the three friends who encounter an angry bear in the woods.
"You don't have to be the fastest runner in the world, you just have to outrun your two friends," Nadler says.