Wild swings in the U.S. stock market escalated to unprecedented levels last week as the Dow Jones Industrial Average gyrated over 400 points on 4 consecutive trading sessions. Market observers agree that the principal catalyst of this turmoil was the decision by S&P to lower the U.S. Government’s credit rating from AAA to AA+. The downgrade and the market’s reaction raise important questions:
- Was the downgrade warranted?
- Will it have a lasting impact on the U.S. and global financial markets and economies?
The downgrade was promptly supported by some conservative economists even as it was condemned by the White House and prominent financial leaders including Warren Buffett. Stirring the controversy was that neither of the other two rating firms, Moody’s and Fitch, reduced their top ratings. Moody’s sharpened its disagreement with its larger competitor on August 8 by emphasizing on its website its reasons for not reducing its rating (moodys.com).
We accept S&P’s own definition of the proper function of credit ratings; they “express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time” (standardandpoors.com). By this standard, the downgrade is dubious. The U.S. Treasury has affirmed clearly that its highest priority is to stand behind U.S Government debt and, with the raising of the debt ceiling by Congress and the President on August 1, there is no legitimate doubt as to its ability and determination to honor this pledge.
To justify its downgrade, S&P executives asserted that they were influenced by the messy, acrimonious struggle between Republicans, Democrats, and the Administration to reach a compromise. Here S&P is introducing criteria for a downgrade that is outside their own definition of the purpose of credit ratings. Congressional and S.E.C. investigations into S&P’s action have been launched, and in particular they will focus on whether S&P was motivated by a desire to influence politics. It is noteworthy that S&P is already under investigation by aggravated Euro Area governments for using sovereign debt downgrades to improperly impact political processes.
The initial fear of economists, policy makers and investors was that the downgrade would damage the U.S. economy by driving stock prices lower and bond yields higher. This has not happened. Key governments, including China, promptly declared last weekend that the downgrade would not impact their purchase of U.S. Treasurys. When markets opened after the weekend, investors increased their appetite for Treasury securities and drove yields to lows not seen since the crisis days of late 2008. For the week, the yield of benchmark 10-year Treasurys fell from 2.56% to 2.24%, while 2-year Treasurys dropped from 0.29% to 0.18%. Obviously, investors ignored S&P’s warning and, to the contrary, established unmistakably that in their view U.S. government securities remain the safest investment in the world. Last week’s trading also indicates that bond investors are shifting from credit agencies like S&P to credit default swaps (insurance premiums paid in the open marketplace by bond investors in order to protect against default) to determine the relative credit risk of sovereign debt. The role of rating agencies in sovereign debt markets is fading.
Will the downgrade of U.S. debt by S&P continue to roil global stock markets? We do not think so. Following three consecutive up days for U.S. stocks, it appears that the initial dramatic impact of the downgrade is already diminishing. If the bond market continues to ignore the downgrade, the stock market will likely follow. The real threat to the U.S. and global equity markets is an inability of U.S. policy makers to take decisive action on the issues of deficit reduction and job creation.
We think that S&P has acted unnecessarily and, given the fragility of the stock market and economy, irresponsibly. Fortunately, we do not think the downgrade will have a lasting impact.