An unconventional Economic Notion

Written by Mashud Abukari

On Friday, August 5, 2011, the rating agency, Standard and Poor’s downgraded the United States long-term credit rating from AAA to AA+.  This downgrade comes as a surprise because it’s the first time the U.S. has ever lost the triple-A rating in the past 94 years. The reason for S&P’s downgrade is that the budget deal announced by Washington in early August of 2011 to advert the government shutdown didn’t do enough to address the gloomy outlook of America’s government finances. S&P said, the downgrade “reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.”

The downgrade was justified because the U.S. fiscal policy outlook remains bleak. Until there is a fundamental change in fiscal policies and a move towards a positive economic outlook, U.S. should not have a triple-A rating in the current economic conditions.  The U.S. economy has weakened considerably during the recent recession and continues to deteriorate even after the exiting from the recession. Labor market conditions are not improving with unemployment still at high levels, employment diffusion index also weaken to 52.2 from 57.7 in August and the percent change in nonfarm payrolls was zero in August. Other economic indicators, like investment in nonresidential structures still remain weak. Aside from these negative indicators, there are weakness in “effectiveness, stability, and predictability” of U.S. policy making and political institutions.

The bond market reaction to the downgrade was surprising and at the same time quite telling about investor sentiment. The yields on Treasury notes fell as the direct result of the downgrade: the benchmark 10-year yield shed 21 basis points, sinking to 2.35% and 30 year bond fell by 18 basis points to 3.67% on the downgrade announcement. In general, one would expect that the Treasury yields would move higher as a result of the downgrade, however, the opposite occurred; yields fell. The reaction by investors suggests that there is little concern about the prospect of U.S. default. It also shows that investors’ appetite for safety is high therefore investors would rather move to safe securities in times of uncertainty.

The unilateral decision to downgrade the U.S. debt rating by S&P is not a major blow to the U.S. economy at present since the two other major rating agencies- Moody’s Investors Service and Fitch Rating- have still affirm their triple-A rating. On the same note, the downgrade in the long term can be problematic since the U.S. government provides a central support for the entire global financial system. The borrowing cost may rise for the U.S. and other sovereign government debt if other rating agencies choose to follow S&P’s lead.

REFERENCE LIST

Dismal Scientist. “What the S&P Downgrade Means for the U.S. Economy,” Moody, 8 Aug. 2011. Web. 02 Oct. 2011. <http://www.economy.com/dismal/pro/article.asp?cid=223895 >

Paletta, Damian, and Matt Phillips. “S&P Downgrades U.S. Debt for First Time.” The Wall Street Journal – Wsj.com. 6 Aug. 2011. Web. 02 Oct. 2011.<http://online.wsj.com/article/SB10001424053111903366504576490841235575386.html>.