The U.S. Debt Downgrade's Ripple Effects

The worldwide reaction to the downgrading of U.S. Treasury debt by Standard & Poor's was swift and shocking. The S&P 500-stock index lost nearly 7% on the first trading day after S&P deemed U.S. debt AA+ quality -- with a negative outlook -- instead of AAA. The loss brought stocks close to official bear-market territory, typically defined as a 20% downturn, before the volatile market swung sharply higher again.

The ultimate irony: Treasury prices soared, as panicked investors sought the world’s favorite safe haven. As money market guru Peter Crane, of Money Fund Intelligence, quipped, “Double-A will become the new triple-A.” Here’s how the downgrade will work itself through the financial landscape.

The Stock Market

Investors had been looking for an excuse to exit the stock market, says Andy Engel, a portfolio manager at the Leuthold Group -- the debt downgrade just provided the trigger. The bears at Leuthold see the S&P ultimately dropping to 950 -- a roughly 30% decline from April’s high -- and are telling clients to raise cash in market rallies. But Jim Stack, at InvesTech Research, says it’s too soon to tell whether we’re seeing yet another correction -- number eight -- within this bull market, or whether we’re in a new bear market. “If the April high was the bull market high, it was unlike any peak I’ve seen in 30 years,” Stack says. There was no advance warning from market bellwethers, and no breakdown in market leadership. And widespread panic selling is more indicative of market bottoms. Recent volatility may induce you to reassess your risk tolerance or do some portfolio tweaking. Just remember that market-timing rarely ends well for most investors. Better to stick to your long-range plan.

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The Economy

The downgrade would have been a non-event had it happened at another time, says Moody’s Analytics economist Mark Zandi. Instead, it came when investor confidence was strained to the limit by debt crises in Europe and our own deficit woes. Usually, recessions begin when economic fundamentals are eroding rapidly -- not the case in the U.S., where businesses are in great financial shape and household income that’s going toward debt service is closing in on record lows. And a key difference from 2008: The banking system is more profitable and better capitalized, says Zandi.

But a persistent crisis of confidence in the stock market could put the economy in a tailspin, Zandi fears. High-income households focus like a laser beam on the stock market because stocks make up so much of their net worth; businesses use the market as a signal for making hiring decisions. He gives the odds of recession as one-in-three.

Consumer Loans

In theory, yields on Treasury bonds -- and rates on consumer loans tied to Treasuries -- should rise after a downgrade as investors demand compensation for higher risk. But for now, a weak economy trumps a debt downgrade and rates are staying low. Mortgage rates, linked directly to Treasury yields, followed Treasuries down despite the downgrade and a subsequent markdown of the credit rating for mortgage giants Fannie Mae and Freddie Mac, which carry the government's implicit guarantee and are dependent on its support. Rates for 30-year fixed-rate loans fell to 4.4%, the lowest level all year. Automakers and affiliated finance companies are well positioned to subsidize market rates to goose sales. Baseline rates for credit cards aren’t budging -- although issuers may insist on wider margins for riskier borrowers if the economy deteriorates.

Once panic subsides and the economy improves, however, Uncle Sam’s downgrade may cause consumers some pain. College financing guru Mark Kantrowitz, of FinAid.org, estimates that rates on bank-funded student loans could rise one-fourth to one-half of a point. Still, says Greg McBride, of Bankrate.com: “People worried about rates skyrocketing have their worries misplaced.”

Savings Rates

Unfortunately, there is no silver lining for savers in the Treasury downgrade. Banks are awash in deposits while loan demand remains weak. No need to raise rates on certificates of deposit or money market accounts to attract deposits -- quite the opposite, in fact, says McBride: “You’re going to see rates go down before they go up.” Money market mutual funds were not affected by S&P’s downgrade, which did not apply to short-term Treasuries (see CASH IN HAND: What the U.S. Debt Downgrade Means to Bond Investors).