Some Impacts of the Downgrade?

Standard & Poor’s, one of three credit rating agencies, downgraded the U.S. federal government’s credit rating to AA+ from AAA.  It is the first time in the agency’s history that it or any other rating agency has downgraded the federal government’s debt.  Two other rating agencies, Moody’s Investors Service and Fitch Ratings, retained their AAA ratings. 

Most analyses on the impact of the downgrade that I have seen have focused on its immediate impact.  I do not know how market participants will react today, nor do I know which other factors such as the debt crisis in Europe or earnings will contribute to investors’ reactions.  Rather, than this immediate focus, I would like to explore the economic implications of the downgrade over a longer time horizon, but I do so lacking a great deal of specific information as I will explain.

I believe that there will be two types of responses: one directly through markets due to reactions of market participants and one indirectly through markets via regulations.  Markets are forward looking.  The debt crisis is not a surprise just as downgrades due to a deteriorating debt to GDP ratio is not a surprise. Many financial economists boil down financial assets to two characteristics: risk and return.  As risk increases, investors must receive a higher expected return.  Other things equal, U.S. government debt will sell at a higher price relative to other assets such as corporate bonds and stock.  As the economy strengthens, and it will at some point, money will flow out of treasuries into these other assets.  In general, the price of corporate bonds and stocks will increase driving down their rates of return.  Firms deemed too big to fail have been able to borrow at close to the government’s rate.  That advantage will lessen because the government’s cost of borrowing will rise relative to corporate borrowers and the value of these firms will fall relative to others. 

Regulation may cause more immediate turmoil from the downgrade than the direct reaction of market participants.  For example, the Basel III regulatory standard, which is accepted by most countries, requires financial institutions to maintain more capital on assets as risk rises.  The downgrade may require some foreign institutions to raise more capital on the U.S. treasuries they own or to sell those treasuries and buy government debt from countries with a AAA rating.  If they sell, prices of U.S. treasuries will fall and interest rates will rise.  I do not know how many foreign governments base their assessment of risk on Standard & Poor’s.  I also don’t know how quickly these foreign financial firms will have to react.  I doubt that many investors have the knowledge that I lack, but I bet that many are currently seeking the same information.