It finally happened. Britain has lost its cherished' AAA credit rating.
Credit rating agency Moody's took the leap on Friday night. It's the first of the big three' agencies to do so. But it won't be the last.
You might think: "So what?" We're hardly in junk territory. The US was downgraded ages ago. And at least we managed to hang on to our AAA rating long enough to wind up the French.
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Yes, it's embarrassing for George Osborne. But the markets have already priced this in. There's nothing to worry about.
That's the view that most pundits are taking.
But I wouldn't be so blas. This matters more than most people think. Here's why
Britain's central bank is panicking and its politicians are desperate
Moody's has dropped Britain's AAA-rating by one notch, to AA1. In short, the ratings agency thinks that growth is going to be weaker than it had expected. As a result, it'll take longer to cut down Britain's debts. Overall, higher debt and slower growth leave Britain more vulnerable to "adverse economic or fiscal shocks."
It's nothing we didn't already know. It was always clear that the government's growth forecasts were too optimistic. The fact that the ratings agencies are only catching up now shows how essentially pointless they are.
The Lex column in the FT even jokes that this is "good news for the UK". After all, when the US lost its AAA rating in August 2011, US Treasuries rallied. And France hasn't collapsed yet either.
In fact, the only AAA-rated countries in the G7 now are Germany and Canada, and they've both got their own problems. Canada has a huge housing bubble that's about ready to pop now that their central bank head Mark Carney is leaving for the UK. And Germany well, it's on the hook for everyone else in the eurozone, so that AAA rating might not last either.
So the AAA badge itself is pretty meaningless.
But sadly, that doesn't mean we can just shrug this off. When the US was downgraded, people panicked and bought the safest asset they could think of which happened to be US government debt. When France was downgraded, it was just one of many problems afflicting the eurozone. In both cases, markets had bigger fish to fry.
The timing for the UK is rather less fortuitous.
Investors might have been getting to grips with the idea that UK growth will be pitiful for years to come, and that debt will be higher. But they are only just starting to grasp the implications of that.
The last couple of weeks have represented a major turning point. First we learned that the Bank of England expects higher inflation, and plans to do nothing about it. Then, we found out that Sir Mervyn King who has previously shown decidedly mixed feelings towards quantitative easing (QE) - actually voted for more this month. (He was outvoted by his other members for only the fourth time ever).
In other words, not only is the Bank tolerating inflation it'd be happy to risk encouraging it in the hope of spurring a bit of growth. That smacks of desperation. And King's inconsistency on QE smacks of panic.
This is a problem, to put it lightly. As I noted earlier this month, much of this is about confidence. A panicky central bank chief and an increasingly desperate government do not make for confidence.
In fact, as Alice Ross and Ralph Atkins point out in the FT, the man who tries to flog our gilts to buyers Robert Stheeman, head of the UK debt management office is clearly feeling a bit twitchy. "I read with interest some comments made by policy makers because it is all about confidence. The confidence of overseas investors is crucial to what we do."
In other words "thanks a million, Merv, for making my job ten times harder".
In this context, the Moody's downgrade matters. Osborne staked his reputation on maintaining the UK's AAA-rating. So losing it has a significant political impact that it didn't have in the US or France. It will encourage Osborne to go for broke to achieve even an illusion of growth. It certainly promises to make the Budget in March an even more fraught affair than usual.
Investors are becoming less forgiving
The other major issue is that investors suddenly have other options. For the last few years, the UK has seemed like a least-worst' bet when compared to the instability of Europe, the turmoil in the Middle East, and the constant dollar-eroding efforts of the Federal Reserve.
But much of that is changing now. And it's leaving the UK a lot less attractive by comparison. For example, while Mervyn King is flailing around like a headless chicken, the US is starting to mutter about ending QE. It might not happen tomorrow. But even talking about it is a major mental readjustment for markets.
Indeed, our own regular writer James Ferguson, co-founder of the MacroStrategy Partnership, thinks that QE in the US could stop as early as the middle of this year. You can find out more on why he thinks this, and what the impact could be, in the current issue of MoneyWeek magazine. If you're not already a subscriber, subscribe to MoneyWeek magazine.
In short, with better options around, as Japanese bank Nomura put it: "Markets are becoming less forgiving".
The pound is now at a two-year low against the dollar. It's already fallen below the $1.53 red zone' highlighted by my colleague Dominic Frisby at the end of last month. There's still plenty of room for it to fall further as John Authers notes in the FT, judged by purchasing power parity', the pound's fair value is around $1.45.
As Jeremy Warner puts it in The Telegraph, the sell-off in the pound "could easily turn into a full-blown rout if foreign investors start to lose faith in the value of sterling assets. This would force a steep rise in interest rates, a fiscal crisis, and another deep recession."
That's not so different to the argument we make in our End of Britain report if you've not seen it, read it here. As for our investment advice, it's the same message we've been hammering home for the last few months diversify away from sterling, and avoid gilts.
And if you fancy taking a punt on sterling falling further, but don't want to spread bet, you could buy the ETFS Short GBP Long USD (LSE: USD2) exchange-traded product. Keep a close eye on it it's not as risky as spread betting, but it's still high risk, and it's not a buy and hold' investment. But if the pound has further to fall over the next few months and I suspect it has it should do well.
This article is taken from the free investment email Money Morning. Sign up to Money Morning here .
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