US Debt: Moody’s AAA / S&P AA+
Moody's reaffirmed its AAA-rating on US government debt last week, while Standard & Poor's lowered it a notch to AA+.  The US now has a split rating from the largest agencies.  The bond market, even though it is not open right now, was well aware that a downgrade was possible, but will still lend 10-year money to the US government under 2.6%.  In fact, after the US was put on credit watch by S&P in mid-July, US yields fell, they did not rise. 

Ten-year interest rates, on Friday, were lower in the US than in Canada, Australia, United Kingdom, France, New Zealand, or Norway – all AAA-rated countries.  In other words, S&P is leading the markets here, not following, as it normally does.  For example, it did not lower its AAA rating on low-income, low credit score, no-doc, no-down-payment loans to homebuyers until the market crashed and became absolutely illiquid.

This downgrade of the US was based, not on an ability to pay bond-holders, but in consideration of the political turmoil the US has just gone through (over the debt deal) and the potential for more political turmoil in the months and years ahead.  None of this is new to the market and the US is still the world's reserve currency, which means actual default is virtually impossible.

The Federal Reserve has said that the downgrade by S&P has absolutely no impact for risk-based capital ratios.  The Fed will still apply a 0% risk-weighted capital requirement on Treasury debt.  Some investors (funds, plans, or other investment vehicles) could be forced to alter their portfolios because of investment guidelines.  However, most investment committees knew this downgrade could happen and also have the flexibility to change these guidelines relatively easily.  In other words, forced selling (or buying) of Treasury, or other, types of debt will likely be benign.  S&P left the short-term debt rating at A-1+, its highest, which means money market funds will not be affected.  We do not look for any kind of major market disturbance.

The equity markets had a rough week and could still be jittery on Sunday night and Monday morning.  Short-sellers will likely try to take advantage of this event.  However, the S&P downgrade alters nothing about the economy or corporate profitability in the short, medium or even long- term.  We still hold to our comments from last week that the markets are over-reacting to fears about the economy, the debt deal, or European financial issues.  (Link)

In the end, while we agree with S&P's sentiment about the direction of US spending patterns, we do not agree with the S&P downgrade.  We believe that S&P is entirely too pessimistic about the ability of the US to pay its debts and solve its problems.  History shows that this country has found a way to alter course before problems became a full-blown crisis.  In fact, the US economy was in much worse shape during the late 1970s and early 1980s.  Elections of the early 1980s changed the country's course then, and a boom of unprecedented magnitude ensued.

If this move by S&P helps the US get more serious about cutting spending, then it will have been a very positive development.  If it influences the political environment by pushing the US to a more conservative set of fiscal values it will be even more positive than that.  There is a titanic battle of economic and political philosophy taking place in the US today.  S&P wants to be a player in this battle, but in the end it will have a relatively minor role.
Posted on Sunday, August 7, 2011 @ 9:31 AM

These posts were prepared by First Trust Advisors L.P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.