How bad would a US credit rating downgrade be?

Last week we looked at some reasons for investing in other countries apart from the U.S. And wouldn’t you know it – this week headlines are abuzz as major credit agency Fitch has threatened to downgrade the nation’s credit rating. From AAA to AA+ that is.

Unless you live and breathe bonds, this may seem like much ado about nothing. After all, how bad can a rating called “AA+” possibly be?  

I basically agree. Credit agencies like Fitch have no inherent authority, and a rating downgrade – especially one this slight – need not have any concrete effects on markets, the government, or the economy.

But. Perception is sometimes more important than reality, so the big question is how people perceive a downgrade like this.  

Why a US credit rating downgrade could be bad news

Three agencies in particular have enough clout to evaluate the creditworthiness of entire nations and be taken seriously: Standard & Poor, Moody’s, and Fitch. Much like your own credit score, their ratings are meant to indicate the likelihood of a given borrower paying back their debts. But in this case, they show the likelihood of a nation paying back its bondholders.

The fear is that a credit downgrade, however small, will make investors more nervous about lending to the US government – i.e. purchasing bonds. US debt would incur higher interest as a result; and while this is nice for bond-buyers, it is bad for most everyone else.

Higher interest on government debt would likely trickle down to higher interest for banks, businesses and consumers. Plus, more of the federal budget would go toward debt payments and away from Medicaid, unemployment insurance, fixing potholes, keeping the lights on at the library, etc. Then GDP decreases, the stock market slumps, etc. etc. etc.  

Bad as all that sounds, a rating downgrade has no inherent power to make these things happen. Credit ratings are only powerful insofar as others base decisions upon them. Some investors and institutions, for example, make it a matter of policy to only hold the highest-rated bonds. So they would react strongly if US debt was downgraded.

But it is unclear if everyone else would.

What happened with the last credit downgrade

US debt is some of the most highly-rated in the world, so we do not have much precedent to go off when trying to guess the effects of a downgrade. But we do have some.

That’s right, the country has had a downgrade happen before. In 2011, S&P did exactly what Fitch is threatening to do now, and downgraded US credit from AAA to AA+. So what happened to interest rates as a result?

Instead of increasing, interest rates decreased after the US credit rating downgrade in 2011.

Oh. Well then.

It would seem that, instead of eschewing US bonds, investors flocked to them – likely because they were anticipating all those downstream effects we just discussed. Higher borrowing costs means lower GDP means poorly-performing stocks. So investors decided it was time to flee to safety… in government bonds, ironically!

Whatever the reason, the point is that interest rates dropped instead of rising, and the expected calamity never happened. This is no guarantee that it will not happen this time, of course. But it does tell us the outcome is far from certain.

The real risk behind a downgrade

Even if Fitch’s threatened downgrade is not a real problem by itself, it suggests the credit agencies see government default as an increased possibility. They may even be hoping the downgrade will spook Congress into action to avoid that possibility. If so, I do not blame them, because the US defaulting on its loans would be a real problem.  

But it would not be the end of the world. It probably would not be the end of the US either. Who knows, it may even be the unpleasant wake-up call needed to force our economy into a new, more sustainable direction.

Either way, I do not think it is a reason for you and me to panic. As we just discussed last week, the global economy is bigger than just America, and you have the tools to invest in it.