As Washington was abuzz with congressmen debating the debt ceiling, the markets had already given its verdict – after so much of political wrangling, the US was more likely to lose its coveted AAA rating than it had ever been in history. S&P’s statement confirms this, when it says that “…the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges …

So what will be the impact of a US downgrade?

For any country (or company), a ratings downgrade means increasing yields, higher interest payments on future borrowings, and loss of face. That is what a lot of people expect to happen for the US also, for instance JP Morgan and Blackrock. Others, most prominently Wilbur Ross, think it’s not a big deal.

It is very difficult for anyone to predict the consequences of this never-before-seen event. While the immediate consequences are obviously negative, over the medium – to – long term, I am inclined to believe that there will be very little, if any, impact.

1. Most bond fund managers mandated to invest in high quality securities mention treasuries separately from AAA securities in their issuing documents, implying that they can maintain positions in treasuries irrespective of their credit rating. So a treasury selloff from bond fund managers may be insignificant and temporary

2. When it comes to sovereign bonds, market perceptions and growth prospects of an economy matter more that credit rating. As the last chart on this link shows, Japanese govt. yields are lower than US in spite of having a rating 3 notches below the US, and Australia has higher yields in spite of the same rating. That clearly is because Australia has been the fastest growing economy in the developed world, while Japan has the slowest growth. So, if the US economy slows down (as recent data suggests), yields are likely to fall rather than rise, irrespective of what S&P says

3. If US growth indeed starts slowing down and credit conditions within the country worsen, the Federal Reserve will at best be inclined to keep low interest rates for longer, or at worse commence with QE3. In either of these scenarios, interest rates remain low

4. Also, low growth and the resultant deteriorating credit quality of American borrowers will force US banks to seek a safe haven in, what else? US treasuries. This will also drive yields southwards

5. Modern finance is built with the US economy at its core. Most analysts use the US 10-year treasury yield as the risk free rate. The people leading the “US downgrade = Global catastrophe” argument say this: A US downgrade will drive up the “risk free rate”, and lead to a rise in discounting rates for all other securities (debt and equity), causing their returns, and hence values to fall. So this assumes that analysts will not see the obvious fact that a US downgrade will not change the fundamentals of any other securities, and mathematical calculations will dominate over on-the-ground realities of other security issuers. As an analyst myself, I refuse to believe this.

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