Ignore the immediate market reaction to the first ever downgrade of US credit – there is bound to be a knee-jerk response. Investors should remember the underlying US fiscal situation is in no worse shape now than it was last Friday just before Standard & Poor’s announced its AA+ rating. The action is merely a trailing indicator of a situation of which investors in the world’s most analysed economy are already well aware. Indeed, since S&P put the US on downgrade alert in April – something that would have triggered a sell-off for any other country – investors in US treasuries have barely batted an eyelid. Yields on 10-year government debt have actually fallen about one-quarter.
Over the medium term, investors are unlikely to rush out of US debt, the dollar, or even US equities en masse. Sure, there are other triple-A rated options, but it is unlikely that significant amounts of money will prefer the UK, France, Germany, or even Finland over the US. As a consequence, US borrowing costs are unlikely to rise materially as a result of the downgrade.
In a global context, investors should keep their minds focused on the here-and-now. Currently, the biggest risk to the world economy is not a US default – the ability to print its own currency means the worst that can happen is a continued gradual weakening of the dollar over decades. Italy and Spain, however, are hostage to the euro – a currency they cannot control. The countries’ borrowing costs have risen sharply over the past month and the German government has refused to contribute more funds to Europe’s bail-out fund.