The US is one step closer to a downgrade – so what now?

The US is one step closer to losing its AAA-credit rating, after a warning shot from credit ratings agency Standard & Poor's. But how worried should investors be? John Stepek investigates.

Stock markets have tumbled. The gold price has surged.

If you were to look at the state of the markets this afternoon without having listened to the news first, you'd think some sort of disaster had happened. Perhaps a fresh aftershock in Japan, or a default by Greece.

But no. It's all down to a pretty short research note put out by credit rating agency Standard & Poor's (S&P). What S&P have done is said that the US might just might, mind have its credit rating downgraded at some point in the next couple of years. And they've put a "negative" outlook on its AAA-rating.

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That's it.

So isn't all this mayhem a bit of an over-reaction? It may seem it. After all, S&P is only stating the obvious. The US regardless of whichever deficit-cutting scheme is adopts, Republican or Democrat is looking at a national debt of around $20 trillion by 2016 (that's assuming the debt ceiling is raised).

And the credit ratings agencies hardly have an impeccable track record. After all, as blogger Barry Ritholz notes, if it wasn't for S&P rubber-stamping dodgy mortgages, then the US wouldn't be in this dreadful fiscal position in the first place.

So why the panic? Firstly, there's the fact that a ratings agency has dared to make this move. The US fiscal situation has been unhealthy for a while, but its AAA rating hasn't been questioned like this for quite some time.

Secondly, it has brought home to investors that the US really does face unusually high political risk right now. With the two parties fighting it out over cuts and tax hikes, there's no guarantee that they'll come up with a package that will stick, or that they'll begin to address the deficit quickly enough to make a noticeable difference to the overall debt burden.

David Beers, S&P's global head of sovereign and international public finance ratings told Bloomberg: "This debate in the country really is just beginning and hard choices are going to have to be made. We're not saying that no agreement is possible. We're just unsure as to the time frame and whether it's going to be seen as credible not just by us but by the broader marketplace."

So does this matter? Right now, probably not. Britain was here before the US, oddly enough. Back before the election, as Goldman Sachs points out, S&P "made a similar change with respect to the UK outlook in May 2009 citing "a material risk that the UK's net general government debt burden may reach a level incompatible with the AAA rating."

The UK ended up getting out of that one but not before announcing it would undertake the biggest, most brutal cutting programme since the 1920s. And even although that later turned out to be a bit of an exaggeration, it's been enough to keep us out of any further trouble with the markets.

More to the point, for the moment, despite the panic in stocks, the S&P review has proved to be something of a 'non-event' in the bond market. The yield on ten-year US Treasuries spiked up briefly (ie the price fell) after the S&P news, but then came back to rest.

So for now, I'd say this is more about markets being hit by a nasty surprise just as other fears, including the eurozone crisis, are rearing their ugly heads. We'll have plenty more warning if and when the US actually gets close to a serious fiscal crisis. What investors should probably be more concerned about right now is the fast-approaching end of quantitative easing (QE2) MoneyWeek regular James Ferguson will be explaining why in the next issue of MoneyWeek, out on Friday.If you're not already a subscriber, subscribe to MoneyWeek magazine.And if you sign up now, you'll be in time to get the issue with James's cover story in it.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.