The Trouble With a Downgrade

Ratings agencies have threatened to downgrade US Treasuries even in the absence of a default. Fair enough, right? If we cannot trust our politicians to make sure our bills get paid on time, then why should anyone think our debts are absolutely risk free? It is clear now that we are in for a messy process, possibly every time a budget decision needs to be made.

Will ratings agencies actually pull the trigger? Who wants to be the one to remove the much vaunted status the US has as the least risky investment in existence? David Greenlaw, an economist from Morgan Stanley reckons they don't have the gut to do it. A downgrade would bring turmoil that nobody wants to be responsible for. Besides, what would they then plug in their models as a risk free rate?

This comes down to responsibility in an interesting way. Actions by congress or ratings agencies will have clear repercussions. If congress does not decide on any long term solution, or the ratings agencies downgrade the US, the resulting sequence of events will lead directly to a responsible party. Economic troubles going forward will not have the ambiguous provenance of our last little financial fiasco.

Uncertainty

Markets react to political uncertainty by delivering volatility. As we have gotten closer to the deadline for a debt ceiling deal, the markets have swung wilder. Today the Nasdaq is down 2.65% and the S&P is down 2.03%.

An outright default is generally agreed to be the most impossible outcome of the situation, but other options aren't necessarily great. A long term deal is most desirable from a market standpoint. Understanding what the fiscal situation will be for years down the line gives more confidence to market participants, even if they don't like the equation. A temporary deal may give a bit of breathing space, but it is unlikely to impress. A temporary deal may only further erode the trust of market participants in our politicians to get important things done in a reasonable manner.