Downplaying a U.S. Ratings Downgrade

By Phil Izzo

Some market watchers are playing down the effect of a U.S. ratings downgrade, but if markets take it in stride that could make the underlying problem even worse.

Standard & Poor’s has said that it may drop the U.S.’s triple-A credit rating to double-A even if the country raises the debt ceiling and manages to avoid default. S&P is looking for the U.S. to make big structural changes to get its long-run debt in order, and despite some discussion between President Barack Obama and House Speaker John Boehner earlier in the debt-ceiling debate, a broad plan looks dead in the water.

That has made a downgrade look likely and has sparked a debate on what effect such an action would have. Moderate think tank Third Way put out a report comparing interest rates in countries that have a triple-A rating with those that have a double-A. The report notes that moving from the neighborhood of Germany, Canada and Hong Kong to the less upscale burg populated by Spain, Japan and Chile could add 0.75 percentage point to bond yields. And some analysts say that could result in the U.S. paying as much as $100 billion more a year in interest on its debt if ratings firms decide to downgrade.

Many others are downplaying the effect of a downgrade. AllianceBernstein wrote in a note that markets aren’t particularly spooked right now, and there isn’t much evidence that a downgrade brings anything new to the table. “If the only change between today and tomorrow is a credit-rating downgrade, history suggests that the market won’t react severely,” they write.

Ratings agency Fitch also said the immediate impact on the market wouldn’t be big. “Over the near-to-medium term, in a moderate downgrade scenario (e.g., to AA), U.S. Treasuries would likely retain their standing as the benchmark security that anchors global fixed-income markets, given their unparalleled liquidity, unique role in the financial system, strong credit profile, and lack of a viable alternative,” Fitch said.

If a downgrade fails to trigger a major market event, that’s good news for investors today, but it raises the risk that politicians will continue their longstanding policy of whistling past the graveyard.

In congressional testimony today, S&P President Deven Sharma issued the warning that continues to go unheeded. “The more important issue is the long term growth rate of the debt,” he said. That refrain has been repeated over and over, from the ratings agencies to Federal Reserve Chairman Ben Bernanke in recent testimony.

Click chart for interactive version.

The actual downgrade isn’t as important as what it represents, a growing U.S. debt that politicians show little willingness to deal with. Look at the chart above of projected debt of some triple-A-rated countries. The U.S. stands out because its trend line continues to rise. (Check out a full interactive graphic here to create your own comparison charts.)

There’s been lots of talk about dealing with the long-run problems, but every time it gets down to the nitty gritty of an actual proposal, the whole thing blows up. The market hasn’t forced the political class to act, and a muted reaction to a downgrade may further embolden them to put off coming to a broad agreement.

With the continued debt crisis in Europe and a stubbornly slow economy pushing investors into the perceived safety Treasurys, a downgrade announcement may just not be enough to spook investors out. That doesn’t mean the emperor’s wearing any clothes, it’s just that everyone’s too scared to point it out. The government would be wise to give him a pair of pants before that kid in the crowd pipes up.

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