Why S&P's Downgrade of the U.S. Means Little

The media has made a ruckus over the U.S. debt ceiling and S&P's downgrade, but the markets are not responding with the same hysteria. In fact, the market has not had much to say about the downgrade. I think S&P's action will have little impact on the economy and financial markets. However, if over the long-term the reasons driving S&P's downgrade continue, the U.S. would be headed for trouble.

Why do I think S&P's downgrade doesn't really matter? First, Moodys and Fitch confirmed a Triple-A rating on the U.S., which means financial institutions that are mandated to hold Triple-A paper do not have to sell Treasuries. Also, the Federal Reserve and the Federal Deposit Insurance Corp. issued a statement saying banks would not have to increase bank capital that was backed by Treasury or other federal-government-backed obligations. Financial institutions could be negatively impacted if S&P's downgrade of the U.S. leads to downgrades of financial institutions. S&P has yet to take any action on this front.
Second, S&P's ratings are just a label; supply and demand still determines the rates the U.S. will pay on its debt. Through this whole debt debacle and subsequent downgrade, Treasury yields have gone down which means the cost for the U.S. to borrow has actually gone down! Treasury yields have fallen because of recession fears, but even before the recent poor economic data was released Treasury yields (except for near term T-bills) were not going up.

The true concern is what will happen over the long-term if the U.S. continues on this path. S&P's downgrade is a first step towards higher borrowing costs. If China and other large holders of U.S. debt decide to diversify away from Treasuries the dollar will slowly lose its reserve status and the cost of financing our debt will go up. This process will play itself out over several years because large holders of U.S. debt will not want to dump large quantities onto the market thus decreasing the value of their Treasuries.

Investors are currently flocking to Treasuries in a "flight to quality" which shows that for now, U.S. Treasuries are still the preferred safe haven for investors.