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Why S&P's Downgrade Of The U.S. Credit Rating May Not Be As Bad As It Sounds

Standard & Poor's just downgraded America's credit rating. This sounds ominous and world-historical, but the impact of the downgrade could be relatively minor. (Here's a news story on the downgrade; here's the full statement from S&P.)

S&P downgraded the U.S. by one notch, from AAA to AA-plus. This was not at all surprising. S&P said this spring that it was considering lowering America's credit rating, and speculation about the downgrade increased over the past few weeks. The U.S. still has AAA ratings from the other two big rating agencies, Moody's and Fitch.

The downgrade is one rating agency saying it's slightly less confident that the U.S. will find the political will to control its debt in the medium- to long-term. S&P is not privy to any secret information; this is just its opinion based on facts available to everyone.

As a rule, investors demand higher interest rates for riskier loans. So if S&P's downgrade worries investors, the U.S. could be forced to pay higher interest on its debt. That would have broad ripple effects, not least because interest rates on mortgages and other loans are tied to government debt.

In fact, though, the downgrade may not have much effect on government interest rates. In a post last week, I laid out three reasons for this. They're worth reprising now:

1. The vast majority of U.S. debt is held by big institutions like pension funds and central banks. Those institutions do their own research on sovereign debt, and don't tend to be heavily influenced by rating agencies. As a result, a downgrade would likely have "little impact on Treasury yields," according to Amitabh Arora, a Citigroup researcher we interviewed in a recent podcast on ratings.

2. Ratings are a factor in financial-industry regulations and in internal policies at financial institutions. But almost all of these regulations and policies treat a AAA rating the same as a AA-plus rating. So a downgrade from AAA to AA-plus is unlikely to trigger much forced selling, Arora said. The nation's bank regulators announced tonight that the one-notch downgrade doesn't affect the way they assess banks' holdings of government debt. And an official at Vanguard, the big mutual fund company, told me last week that "a downgrade from AAA would not trigger any events inside our funds."

3. When other countries were downgraded from AAA to AA, the effect was minimal in most cases, according to this this report from AllianceBernstein. Japan, for cexample, was downgraded in 2009, to little effect. When Canada was downgraded in 1994, its interest rates briefly went up by half a percentage point — but two months later, rates had come back down to where they were before the downgrade. (Canada later regained its AAA rating, by the way.)

The big caveat: Why the downgrade might matter in spite of all that

U.S. Treasuries are traditionally considered to be a risk-free investment, and this is the first time the U.S. has ever been downgraded. It's unclear how the downgrade will be perceived in the broader narrative of the U.S. economy and its role in the world. This sounds all soft and fuzzy. But soft and fuzzy matters. Sentiment matters.

The downgrade adds to the recent wave of grim economic news. The economy barely grew at all in the first half of the year; the debt-ceiling debate took the country to the brink of default; the stock market dove; and the unemployment rate fell last month only because people gave up looking for jobs.

In the short term, this kind of news can make business owners reluctant to hire. It can make investors decide to sell their stocks.

Treasuries (and, more generally, the U.S. dollar) are the foundation of much of the financial system not just in the U.S., but around the world. This means that investors around the world are eager to lend the U.S. money, in its own currency, at very low interest rates.

Nothing lasts forever, and at some point in the future, this will change. The U.S. dollar, and U.S. Treasuries, will no longer hold the singular place they hold now in the global economy.

Today's downgrade alone isn't likely to play a defining role in that shift. But it could be one more small step in that direction.

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