The Downgrade Should Matter to Washington More Than to the Market

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 |  Includes: IEF, TLT
by: Brian Rezny

It happened to Canada in 1992. The country’s sovereign credit rating was lowered to AA+. And the policy response: a ‘thoughtful’ review that resulted in slashed spendingand brought the country to a budget surplus within three years.

As impressive as that was, it took 10 years to get that AAA rating back.

The U.S. has enjoyed a AAA rating for 70 years. This was the first-ever downgrade of U.S. government debtbut not necessarily the last.

Of course, Washington didn’t applaud the move, and the president wasted no time reproving the decision: “We’ve always been and always will be a AAA country”.

But the downgrade itself isn’t what matters here (it wasn’t a surprise, after all). What matters is the reasoning behind it, and the market's reaction to it.

This is not about economicsit’s about politics. Our sovereign debt wasn’t downgraded because there was any real possibility of defaultwe have printing presses to handle that.

And S&P made it clear that this was a political downgrade: “The political brinkmanship of recent months highlights what we see as America’s governance and policy making becoming less stable, less effective, and less predictable (this) weakens the government’s ability to manage public finances.”

And to turn the knife: “Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a ‘AAA’ rating.”

As much as S&P made it plain that it was grading our political process, the bond market made it plain that it was irrelevant.

The Treasury bond market thumbed its collective nose at the agency as investors piled into the very debt that was downgraded, driving yields to record lows.

This is understandable: there simply is no safer or more liquid alternative, so Treasuries are bound to benefit from the fear trade.

The result is that Treasury bond funds are looking frothy. And looking at iShares IEF as a proxy for the market, that goes for intermediate-term securities:


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Source: stockcharts.com

As well as long-term, TLT:

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Source: stockcharts.com

S&P’s decision clearly had no negative impact on the Treasury market. And let’s not forget that the agency, along with Moody’s and Fitch’s, lost credibility by handing AAA ratings to risky mortgage backed securities, which fed the real estate bubble and “greased the skids of the financial crisis,” according to Time.

Still, credible or not, relevant or not, the downgrade happened for a reason. It was never a question of whether the U.S. would be able to honor its obligations; it was a question of whether our elected officials could stop all of the political posturing long enough to come up with a deal that will reduce the debt burden to a sustainable level. This was a warning, and Washington would be wise to heed it.

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