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Last Friday, in a widely telegraphed move, Standard & Poor's downgraded America's credit rating one notch from AAA to AA+. The real surprise was the timing, not the downgrade. Nonetheless, officials at the Treasury Department went ballistic, in part due to an error in the calculation of projected debt. Yet after acknowledging the error, S&P stood by its downgrade.

Whether the downgrade was deserved or not, it has clearly shaken up financial markets around the world. Stocks, in particular, sold off everywhere. Yet U.S. bonds rallied. This seemingly nonsensical reaction in the bond market is due to investors trying to reduce risk. They are selling "risky" stocks and buying "safe" bonds. In other words, they believe the S&P downgrade is more a comment about dysfunction in the U.S. government than it is a concern about the government's inability to pay back its debts. As for stocks, the lower they go, the safer they get.

What comes next? No doubt the other rating agencies, Moody's and Fitch, are doing their homework and might issue downgrades of their own. I don't expect that to happen in the very near future. More likely, Moody's and Fitch will wait until they see how Washington reacts. The recent agreement to raise the debt ceiling and reduce spending requires the formation of a commission to come up with the cuts. Members of this commission have yet to be named. If the commission looks credible and if it makes serious recommendations in a timely fashion, Moody's and Fitch will likely maintain their prime ratings on U.S. credit. But if the commission turns out to be another dysfunctional political group that cannot agree on serious spending cuts, more ratings cuts are likely.

Now that S&P has downgraded America, you have to wonder about the remaining countries that still enjoy AAA ratings. France, in particular, looks vulnerable. 10-year notes in France are yielding significantly more than 10-year notes in America--even after America's downgrade. In other words, investors are telling S&P it is wrong. They perceive French bonds to be riskier. Remember, the U.S. can always print more money. France no longer has its own currency. After downgrading the U.S., it would be entirely inconsistent for S&P to maintain its prime rating on France. I expect a downgrade of France will be the next shoe to drop.

Source: Downgrade Aftermath: Is France Next?