S&P Downgrades U.S. Treasury Debt

S&P Downgrades U.S. Debt

by CNBC August 5, 2011

The United States lost its top-notch triple-A credit rating from Standard & Poor’s Friday, in a dramatic reversal of fortune for the world’s largest economy. S&P cut the long-term U.S. credit rating by one notch to AA-plus on concerns about growing budget deficits.

“The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics,” S&P said in a statement.

“More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011,” the statement said.

U.S. Treasurys, once indisputably seen as the safest investment in the world, are now rated lower than bonds issued by countries such as the UK, Germany, France or Canada.

On July 14, S&P put the government on a credit watch with negative implications, meaning there was at least a one in two chance the U.S.’s long-term debt would be downgraded within 90 days.

Just a couple of years ago this was considered unthinkable. Of course, at that time no one believed that the U.S. dollar would lose reserve currency status for decades at least. Now, as we have documented in repeated posts, the reserve status is at serious risk. Tonight’s downgrade of Treasury debt certainly does not help.

The main point is that we are now fully vulnerable to a Phase Three attack as we described starting in early 2009. Here are direct quotes from the report we prepared for the Pentagon:

“The risk of a Phase Three has quickly emerged, suggesting a potential direct economic attack on the U.S. Treasury and U.S. dollar. Such an event has already been discussed by finance ministers in major emerging market nations such as China and Russia as well as Iran and the Arab states. A focused effort to collapse the dollar by dumping Treasury bonds has grave implications including the possibility of a downgrading of U.S. debt forcing rapidly rising interest rates and a collapse of the American economy. In short, a bear raid against the U.S. financial system remains possible and may even be likely.”

While Phase One and Phase Two were troubling, the U.S. economy eventually was able to respond and the markets stabilized. Unfortunately, the response has saddled the U.S. Treasury with substantial debt. At the same time, the Federal Reserve has massively increased the money supply in response. In total, an estimated $12.8 trillion of economic stimulus has been put into the pipeline by the U.S. government and monetary authorities . . . For context, $12.8 trillion is roughly in line with total U.S. GDP and sharply greater than the value of all U.S. stocks at current prices. It is also roughly equivalent to the amount of price decline for all American assets, peak to trough, as a result of the financial crisis. It also is estimated to produce massive annual Federal budget deficits…

The concern is that the response to the recent collapse by itself will strain available economic resources for some time with large budget deficits and high inflation risks. The situation would be made significantly worse in the event of further economic attack. It is in this vein that a potential Phase Three must be considered.

Based on the assumed nature of Phase One and Phase Two, a Phase Three attack would likely involve dumping of U.S. Treasuries and a trashing of the dollar, removing it from reserve currency status. This is clearly foreseeable as a risk and even could float under the cover of a natural outcome in much the same way that Phases One and Two potentially have been hidden.

The implications are extremely serious. If the dollar were not the reserve currency, there would be a mass dumping of Treasury instruments by foreign holders. Treasury interest rates would skyrocket, further worsening the annual deficits due to sharply higher interest payments on expanding debts. The Treasury would have to raise taxes dramatically, further dampening growth or the Federal Reserve would be forced to monetize the debt, worsening inflation concerns.”

Events are accelerating quickly now. The only thing that currently stands in the way of a full fledged Phase Three attack at this point is the fact that much of the world continues to buy Treasury Bonds for their perceived safety and the dollar’s reserve currency status. Be forewarned, however, that these are both under assault right now.