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On Friday, August 5, Standard and Poor’s downgraded U.S. debt from AAA to AA+, and assigned a negative outlook to U.S. debt. In its press release, S&P directly addressed the contentious squabbling on Capitol Hill, and the clumsy spectacle of Obama, Boehner and the upstart Tea Party faction of the Republican Party wrangling over the raising of the debt ceiling, a process that had previously been routinely approved as a matter of course.

In a stinging rebuke of the current dysfunctional political climate, S&P wrote “We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process. We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade.”

S&P followed up by discussing its long-term outlook for U.S. debt: “The outlook on the long-term rating is negative. We could lower the long-term rating to ‘AA’ within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.”

Russ Winter of Winter Watch at Wall Street Examiner was not too impressed with how the Obama administration and Congress have been handling events, and not too displeased with S&P’s takedown. He wrote, “Par for the course, the White House engages in goonery when Standard Poor finally does the debt downgrade deed. They spent most of their effort with push back and trying to embarrass S&P. The $2 trillion twisting the number reference from the White House (Timmy “Eddie Haskell” Geithner) involves a 10-year projection of GDP growth and pressuring S&P to accept an inflated number, which they did. BFD (big effing deal). Over the next several months, all these government baselines are going to fall apart anyway. I am no fan of S&P and love to see these cat fights, but this sure points to the complete lack of adult presence in the White House. What was more incredible is that just days before this came, Presidente Hopium was on the stump calling for more FY 2012 stimulus and deficits off the already understated FY 2012 baseline of $1.1 trillion. That reason alone explains why S&P has a negative watch on top of this downgrade.

“Some wags are saying this downgrade is already built in, but with the level of cognitive dissonance in the market I say otherwise. I am sure all the government put mucky mucks are meeting over the weekend and are stirring and preparing their usual toxins to stem any blowback. In actuality the only step that should be taken here is for the Fed to back Treasury collateral 100%, end of story. Unfortunately, these guys are like pedophiles, and have to use these situations to pad the wallets of their cronies.”

Bruce Krasting asked and answered, “What to make of the move by S&P? I will tell you that I was surprised that it happened this weekend. I expected that S&P would have given the US till November to sort things out. From the news reports, it appears that the White House and Treasury were equally unprepared for this to happen now. Some thoughts:

“It is quite likely that we will see some interesting market action come Sunday night as this news is digested. But I will stick my neck out and say that once the dust settles a bit, the ratings drop is not going to have a significant effect (for now).

“It looks as if the US is going to have a split rating. (AAA {equivalent} by Fitch/Moody’s, and AA+ by S&P.) If this were a high-grade corporate credit, the split rating status would make no difference in how the underlying bonds trade. I doubt that the S&P action will have a different (lasting) consequence.” (On the S&P ratings move)

China and US debt
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China is the largest holder of U.S. debt, and the S&P’s downgrade presented an opportunity for the Chinese government to sharply admonish the U.S. government through the state-run Xinhua News Agency: “The U.S. government has to come to term with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone ... China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s Dollar assets.” Xinhua suggested that the U.S. slash its “gigantic military expenditure and bloated social welfare costs” and accept international supervision over U.S. Dollar issues. (China rips U.S. on debt-rating downgrade)

Theoretically, the downgrade might make U.S. debt less attractive to the rest of the world, and might cause China to stop buying so much of it. However, Michael Pettis, finance professor at Peking University’s Guanghua School of Management, argues that this is very unlikely. “Is the PBoC going to stop buying USG bonds? Once again we are hearing worried noises from various sectors about the possibility of a reduction in Chinese purchases of USG bonds.

“The threat of a looming U.S. default seems to be driving this renewed concern, although I am not sure that the PBoC really is worried about not getting its money back. After all if the US defaults, it will be mainly a technical default that will certainly be made good one way or the other. Since the PBoC doesn’t have to worry about mark-to-market losses, unlike mutual funds, I think for China this is largely an economic nonevent (not that there isn’t good mileage in pointing to the sheer silliness of the U.S. political process). Still, for domestic political reasons, it needs to be seen huffing and puffing over American irresponsibility ...

“Remember that the PBoC does not purchase huge amounts of USG bonds because it has a lot of money lying around and doesn’t know what to do with it. Its purchase of USG bonds is simply a function of its trade policy.”

Mish Shedlock agreed. “Pettis makes an irrefutable mathematical analysis that shows the idea the U.S. should fear the day foreigners, especially China, would stop buying U.S. treasuries is silliness. Let’s look at this from another point of view. Congress, the president, Bernanke, and many others all want the RMB (Yuan) to rise.

“If the Yuan rises in value versus the US dollar, the other side of the mathematical equation says the US trade deficit with China will shrink and China’s unemployment rate will rise. China, fearing unrest, does not want rising unemployment. Thus, in spite of all the misguided huffing and puffing of numerous analysts, it is China who fears not buying US debt. Otherwise, they would not buy it!” (Reserve Currency Curse: Idea China to Stop Buying Treasuries After S&P Downgrade is Fallacious; US Would Welcome China Not Buying US Treasuries!)

In contrast to a general reaction of disapproval and anger over the S&P's decision to downgrade U.S. debt, Bill Gross took his hat off and praised them, "I have been criticizing them and Moody's and Fitch for a long time. Moody's and Fitch are on the "S" list. I think S&P finally demonstrated some spine. S&P finally got it right. They spoke to a dysfunctional political system and deficits as far as the eye can see. They are enforcing some discipline." (Bill Gross Tells The Truth: "S&P Finally Got It Right. They Are Enforcing Some Discipline. My Hat Is Off To Them", Zero Hedge) In examining the S&P's move, it's natural to wonder about its motives - politics, money, or just a desire to (finally) do the right thing? A separate question is whether the U.S. deserves an AAA rating or not. Those who find fault with the S&P's downgrade, should consider that second question as well.

Lee Adler of the Wall Street Examiner discussed the overall health of the economy, as measured uniquely in food stamps. “Total food stamp recipients rose by 1.1 million in May. That represented a dramatic acceleration from the recent rate. Enough QE2 had trickled down from December to April to slow the growth rate of people entering the program to about 100,000 per month. The last time we saw an acceleration of this magnitude was in September 2008. That was at the beginning of the 2008 crash in the stock market and economy.

“This rise in food stamp use confirms the evidence I have been tracking in the Professional Edition Treasury updates showing a sharp drop in government withholding tax receipts in May, suggesting the return of the recession that had been hidden by the government’s propping of the markets and economy. I had repeatedly warned that once the propping stopped, the markets would collapse, and that once government stimulus payments were withdrawn, the economy would return to contraction. In recent weeks, I have reported in the Treasury updates and have mentioned on our Radio Free Wall Street podcasts that it appeared that the economy had suddenly gone into free fall beginning in May. This data on the food stamp program tends to confirm that.” (See chart below, note the number of people on food stamps is inverted.)

Graphic866
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Dungeons and Downgrades