S&P Downgrade: True to their word

For most of July the political focus on revising the debt ceiling has been a red herring.
The real driver of the rapid fall in bond yields and equity market weakness has been worries that the US and European economies will have slow growth for many years as they work off the pre GFC excesses. Alongside recent weak US data, the debt ceiling revision has reminded markets that policymakers are running out of tools to continually fuel the recovery themselves.  

At one level, S&P downgrading US debt from AAA makes less sense as the US only issues domestic currency debt.  It is highly unlikely to ever need to default on US dollar debt as technically the US can just print money to inflate anyway the value of its old debts - a benefit of not being "trapped" in a currency union. Furthermore, as the world's current reserve currency, the US is in the unique position in that the world has been a natural holder of US debt. 

We think that the S&P rating decision reflects an opinion that they now view the US to be blatantly abusing that privileged position. Clearly the largest holder of US debt, China, agrees with S&P's statements over the weekend. It was most disappointing that US politicians used the review of the debt ceiling for political grandstanding, illustrating a lack of seriousness about the need for a clear plan and united front to sort things out and establish a sustainable path for US debt reduction. The S&P decision can be seen as a direct response to a shambolic US political system in need of a wakeup. They have certainly picked a fight, but a fight that was forewarned in April when they said "the negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years. The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012."

In the medium to long term a debt downgrade should result in higher US bond yields and lower US currency.