S&P's downgrade of the U.S. credit rating

S&P's downgrade of the U.S. credit rating is a recognition that the U.S. fiscal situation is out of balance. Meaningful and unforeseen long-term financial consequences should overshadow short-term uncertainty.

S&P's Decision Reflects Long Term Fiscal Imbalances

Last week, Standard and Poor's (S&P) reduced the national AAA credit rating one notch to AA+, while maintaining the negative long-term outlook. Despite the move, the United States still enjoys a high credit rating and is not expected to face difficulty meeting its debt service in the near term. In addition, as many observers have been quick to point out, U.S. debt is denominated in dollars and the United States retains an independent monetary policy, unlike Greece and Portugal.

Yet, the value of the dollar versus the Swiss franc or an ounce of gold suggests that there is concern about inflation and exchange rate risk with U.S. debt. The S&P downgrade obviously has consequences. By itself, the downgrade means the U.S. is no longer default risk-free and this highlights the threat that the nation's weakening finances present to our long-term, and possibly intermediate-term, ability to meet our obligations given the mix of dollar, interest rates and inflation.

Eggshell Is the New White

Some analysts have noted that the new default setting for "risk-free" may become AA+. The immediate response from finance ministers from the world's largest economies was to reaffirm their support for the U.S. Treasury and reiterate that they would not change their investment policies in regard to U.S. debt. The Federal Reserve also released a statement reaffirming that the weights for U.S. Treasury securities and agency debt for default risk-based capital purposes were unchanged following the downgrade. That said, we would caution that these public statements of support do not alter the economic reality of large deficits. Further out, in the next three to five years, economic risks will clearly need to be re-priced and this will likely mean higher borrowing costs for most U.S. borrowers.

The decision by S&P was not a total surprise. The debt ceiling compromise, which cuts between $2.1 trillion and $2.4 trillion off the deficit over the next ten years fell well short of the $4 trillion called for by S&P weeks earlier. The agreement also did not deal with entitlement spending. The failure to deal with the long-run deficit trend is the key issue for investors.

The most significant consequences of the rating downgrade will be in the intermediate term. By maintaining a negative outlook on the U.S. credit rating, S&P has served notice that a further downgrade is likely if more progress is not made at upcoming deficit reduction meetings with real reforms to taxes and entitlement spending over the next few years. The long-term consequences of our nation's unsustainable federal budget picture are now staring us straight in the face and tough decisions will need to be made soon on how much we can afford to spend on Social Security, Medicare, Medicaid and other social programs. Tax structure and non entitlement structure may also need to be reformed.

By M Zohaib Gadit