Tuesday, April 26, 2011

US Sovereign Debt Rating

Last week, Standard & Poor's rating agency decreased its outlook on the rating of US debt. Because of the quick and strong stock market recovery and because the idea of US default seems absurd, this news event has been deemed immaterial. This is not the case.

If the quality of US debt is downgraded, investors will demand a higher rate of return from it, i.e., an increase in interest rates. Institutions with restrictions on debt quality may also need to rebalanced portfolios consisting of US treasures. This will also result in higher interest rates. Finally, if the dollar remains weak, it is yet another deterrent to foreign investors who would have a lower return when interest payments are converted to their local currency.

There is no question that higher interest rates are "bad for the economy." Because of the reasons stated above, my conclusion is that any other negative developments regarding the quality of US debt may result in a more enduring stock and bond market reaction, after some initial buying by anyone presuming that the market will treat this news release the same as the one on April 18th.

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