S&P Downgrade

my comments:


S&P and Market Commentary August 6, 2011

To the Master's honor all must turn, each in its track, without a sound, forever tracing Newton's ground.

-Albert Einstein (regarding Isaac Newton)

Standard & Poors has downgraded U.S. debt due to “uncertainty” regarding the political process and looming budget deficit discussions. Market pundits have already begun to wax poetically about the decline of U.S. influence and the inevitability of rate rises in the U.S. because of the downgrades.
The opinion of S&P is to be respected, but just as Einstein respected Isaac Newton’s contributions to physics, he was certainly not afraid to point out limitations and errors in Newtonian physics. We must do the same here. What follows below begins with some theoretical point, and then drills down to the specific case here.

The U.S. cannot default in debt in its own currency. Its ability to make payments on Securities Accounts at the Fed held by foreigners and domestic firms is a simple matter of changing spreadsheet entries. There are obvious inflation ramifications from making payments without regard to price stability, but that is another, separate, issue. Let me repeat: The ability to make payments denominated in U.S. dollars should never be in question.

S&P cites governance and policymaking concerns as reasons for the downgrade. This is remarkable given the travails of the rest of the world. It is also notable that by all quantitative measures, the U.S. is in excellent position with Debt/GDP levels rising (given transitory economic conditions) but manageable. It appears to me that S&P simply felt cornered and that their credibility was threatened if they did not do "something". The other rating agencies have taken this opportunity to step away from S&P and distinguish themselves by appearing calm and sensible.

What This Means For Monday and beyond:

I expect financial assets in the U.S. to rise. Stocks may experience a slight decline for the opening hour, but after this initial period we should experience gains. Going forward, The term structure of rates will likely compress (yields FALLING) as the market ignores S&P’s decision. One only has to recall the downgrades (again, by S&P) of Japan in January and the resulting reaction of the markets to see this decision will be ignored.