The significance of the U.S. losing its AAA credit rating from Standard & Poor’s represents a clarion call to Washington that fiscal irresponsibility does have consequences. However, both Moody’s and Fitch recently affirmed the U.S. AAA rating, and barring any sudden change in finances, current rating levels from the three credit rating agencies should remain unchanged in the near-term.
The next step for S&P is to reduce the rating of all municipalities and financial institutions whose current rating is AAA, and which will now be downgraded because of S&P’s rule that no municipality or financial institution can be rated above a country’s sovereign credit rating. This means there are scores of municipalities and insurance companies and banks that will be downgraded, probably as soon as today to AA+, the sovereign ceiling. The shock of this mass downgrade will no doubt top headlines near-term, but following this action, news on the ratings front should melt into the background. The more serious clear and present danger remains the possibility of Italy and Spain being engulfed in the ongoing European debt crisis.
Today’s intervention by the ECB drove yields on Italian and Spanish debt sharply lower. Prior to the intervention, yields for the 10-year debt of both countries topped 6%. Following the ECB’s purchase, Bloomberg is reporting that Italian 10-year debt fell to 5.39% while Spanish 10-year debt fell to 5.3%. The significance of these rates sits with the interest expense both countries will be faced with as they attempt to cover budget deficits and roll-over maturing debt. When 10-year yields of Irish, Portuguese, and Italian debt breached 7%, the governments of all three countries were forced to seek a bailout, and shelter from capital markets.
Today’s joint statement from German Prime Minster Merkel and French Prime Minister Sarkozy was a non-event. Their attempt to talk up budget austerity measures of both Italy and Spain will hardly dissuade nervous investors to increase their aversion to European sovereign debt, and to anything having to do with Europe’s financial institutions that are chock-full of such debt.
With ratification of the EFSF not expected till at least late September, it falls on the European Central Bank to hold things together. Italy’s debt totals 2.6 trillion EUR. Given this, the ECB could be required to spend well over 1 trillion EUR in bond buying. This represents money printing on a near-Federal Reserve scale – no small feat. Furthermore, as is obvious to most, at 440 million EUR, the EFSF is too small to deal with either Italy or Spain.
While this is going on, continued market volatility will increase the risk that the global economy is heading for a serious slowdown. The evidence to date indicates that the U.S. is operating at stall speed, and it would not take much to push the economy back into recession. This obviously has negative implications for major manufacturing exporting nation such as China, Japan, Germany, and South Korea. This in turn would have negative consequences for major commodity exporters such as Canada, Australia, Brazil, and Russia.
The downgrade of the U.S. AAA rating by S&P is serious, and is clearly weighing on investor sentiment today. However, following the accompanying downgrade of those borrowers that are impacted by the sovereign ceiling, market focus will return to Europe and the very real threat that the situation in Italy and Spain will deteriorate, threatening an implosion of the European banking sector and pushing the global economy back into recession.