US downgraded to AA

Well it looks like S&P is the ratings agency with courage. After the close, they downgraded US Treasury debt to AA+ with a negative outlook. The US has been rated AAA since 1917 when credit rating first started. Assuming they don’t get arrested on charges of terrorism or something, I expect that a few other AAA sovereigns may soon follow. I don’t actually expect this to cause problems but who knows. One thing it does do is slightly raise the risk and volatility of everything going forward. All financial algorithms rely on a “risk-free” rate at their core – and that is what the US Treasury market has functioned as for the last 30 years – ever since financial algorithms crossed from academia to Wall Street. That risk-free rate is now, absolutely, a little bit riskier than it was yesterday. At the margins, that could really explode some highly leveraged multi-gazillion derivatives market. It will certainly serve as a slight incentive to deleverage. It could also cause some substantive problems at some money market funds. That said, it is only long-term debt that is now rated as AA – and I suspect short-term debt is at the core of derivatives and algorithms. Here are S&P’s comments.

The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.

Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a ‘AAA’ rating and with ‘AAA’ rated sovereign peers (see Sovereign Government Rating Methodology and Assumptions,” June 30, 2011, especially Paragraphs 36-41). In our view, the difficulty in framing a consensus on fiscal policy weakens the government’s ability to manage public finances and diverts attention from the debate over how to achieve more balanced and dynamic economic growth in an era of fiscal stringency and private-sector deleveraging (ibid). A new political consensus might (or might not) emerge after the 2012 elections, but we believe that by then, the government debt burden will likely be higher, the needed medium-term fiscal adjustment potentially greater, and the inflection point on the U.S. population’s demographics and other age-related spending drivers closer at hand (see “Global Aging 2011: In The U.S., Going Gray Will Likely Cost Even More Green, Now,” June 21, 2011).

Standard & Poor’s takes no position on the mix of spending and revenue measures that Congress and the Administration might conclude is appropriate for putting the U.S.’s finances on a sustainable footing.

This news does explain the markets today. The ratings agencies always leak the news of sovereign downgrades to the government. And our wholesome public servants at Treasury quite obviously feathered their own nests and provided inside information to their Wall Street buddies. Yet another reason why the time has probably now passed for peaceful change.

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