Don't shoot the messenger. The downgrade of U.S. government debt by Standard & Poor’s on Aug. 5 is the result of policies pursued over many years that rely on the U.S. being the world's reserve currency. Policymakers have forgotten that the status must be earned — it’s not a birthright.
Ratings agencies don't want to be caught late in downgrading anyone these days. As such, many may initially shrug off the downgrade, especially since S&P only points out the obvious, which presumably should already be priced in. That said, there is no way to put a positive spin on the downgrade, especially given the negative outlook that accompanied it.
Initial bond reaction may be a rebalancing of some portfolios to increase average security quality. This may have the ironic effect of increasing allocations to Treasury securities. However, while this logic may apply to select U.S. institutional managers, international managers may veer to other securities.
One beneficiary has been corporate bonds — the market appears to embrace some corporations as more creditworthy than the U.S. government. Foreign institutional managers, however, may choose sovereigns elsewhere, not necessarily immediately, but over time.
And in general, the downgrade may precipitate deleveraging, as more collateral may be required. Recently, we have seen signals that U.S. regulators won't require more collateral, but market forces may still move in that direction, if only on the margin (pun intended).
Net, we see a slight negative for commodity currencies as part of the deleveraging trend, but a plus for the euro as the playing field is leveled — the Chinese now have the greenlight to diversify in earnest out of the U.S. dollar. Other Asian currencies should also appreciate, although it may only happen in the medium term.
Keep an eye on the Fed this week. We expect them to move closer to, or even announce that maturing Treasury securities will be invested in the middle of the yield curve. That should overwhelm the S&P headlines in the short term, causing dollar weakness across the board.
Long term, more pronounced damage is likely to occur in the bond market, but like a frog in a boiling pot, the pundits will likely shrug off this view, as the initial bond market reaction may not be too severe. Politicians will simply complain, but not change. And that will cause further downgrades.
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