An infectious downgrade

Standard and Poors must be feeling god-like these days. A downgrade of US credit rating by the credit rating agency from AAA to AA+ brought the US stock market down to its knees. It witnessed the worst week in two years and investors lost over $1 trillion on Monday alone, with the domino affecting other major stock markets around the world too. The most powerful man in the world - president of the US - was shaken by the agencys downgrade, and many were concerned this could trigger another recession. Gold prices went up, while oil prices scampered down, creating furors in commodity markets. Such volatility in the order of time is enough reasons to make S&P feel like S&P Almighty. The story started with the US closing in on its debt ceiling of nearly $14.3 trillion by mid-May this year. While this called for the debt ceiling to be raised urgently, it also called for the US to implement some measures to enforce better fiscal discipline in the economy. When the legislation for a heightened debt ceiling was passed earlier this month, the House also pledged to cut federal spending by over $2 trillion over a decade. But this was "well short of the $4 trillion in savings S&P had called for as a good down payment on fixing Americas finances", as quoted by Reuters. Yet, ironically, the concerns one would naturally expect from a US downgrade were not materialised considerably. In fact, the demand for US treasuries increased on Monday so much so that two-year US treasury yields hit an all-time low of 0.24 percent, while 10-year treasuries also saw a decline in yields. This decline in yields (which happens when greater demand of bonds drives prices up and yields down) comes despite treasury bonds being rated lower, and reflects that investors still regard US treasuries to be a safe haven when stock and commodity markets are dillydallying. However, the impact of the downgrade is likely to affect US treasury yields in a longer span of time. US government debt makes the bulk of holdings for central banks of most countries, banks and even pension funds and private investors. A downgrade right now means that many of these holdings will probably be liquidated, meaning that not only US treasuries, but also the dollar - which did show a knee-jerk decline in response to the downgrade - will see some waning of investor interest as more time lapses. Yet, there is some respite as the US treasuries are still considered the most liquid of all assets, and theres no alternative to that yet. China, the largest foreign holder of US debt - holding treasuries of around $1.2 trillion - is in a catch 22 situation because if it sells its US bond holdings, it would cause the much-debated Yuan to appreciate. But S&Ps downgrade has raised warning bells for the country to put its house (pun intended) in order, especially on the fiscal front. While China may have called for the creation of an alternate global reserve currency, this will take quite a lot of time. Till then, its not only in US, but also in global interest, that the economy reel back from its woes and work harder towards getting on the track of recovery.