2008 Redux?

Following Standard & Poor’s cutting its rating on US long-term debt late Friday from AAA to AA+, the US stock market fell significantly today: the Dow Jones industrial average had a one-day decline of more than 600 points (over 5 percent) and the Nasdaq dropped close to 200 points (nearly 7 percent).

Let's take a deep breath.  Some refreshers:

• S&P is only one of the three big credit ratings agencies.  The other two, Moody's and Fitch, did not downgrade US debt (though they did change their outlooks to "negative").  However, remember that the ratings agencies played a significant role in their overly optimistic ratings of structured debt securities which were instrumental in the 2008 crash.  It's arguable that having been caught with their pants down, S&P is reacting rashly in the opposite direction, seeing danger where there is none.  But ratings are as much a dart game as they are a science and have been called, among other things, "substandard and porous."
• However, because of the interconnectedness of the US financial sector, the downgrade of US debt will have (and has had) direct follow-on effects: specifically, the downgrade today of the debt of Fannie and Freddie Mac, and of DTCC, the central depository for United States securities, all of which rely significantly on the US government. 
• Downgrades are significant because many "safe" investment vehicles (such as money market funds and low risk pension funds) have mandated investment rules, which may include, for example, a rule that such funds invest only in AAA rated securities.  The downgrade of US debt (and subsequent downgrade of other US backed securities as well as the as-yet-unseen ancillary effects of the downgrade) may lead to massive sell-offs by these funds, fueled by nothing but their mandates.
• Despite all of the above, IF investors are genuinely worried about default by the US government (which is what a downgrade signals), then the interest rate on 10-year Treasury bonds should be soaring (because the likelihood that the US government will continue to honor its debt in 10 years should have just deteriorated significantly).  Instead, that interest rate has actually edged down today. 
• What happened today is generally being seen as a flight from securities to "safe havens" (which includes US Treasuries and gold, which broke all-time highs again today).
• The fear is most likely driven by a renewed sense that the global economic outlook is bleak.  Most are speculating that the continued deterioration of Eurozone sovereign debt is the main driver of this fear, but the botched debt deal (see below) and the S&P downgrade are likely contributing to an overall sense that a double dip is imminent.
• There is definitely an element of psychological fear in today's market gyrations.  Volatility, measured via the VIX (or fear index) was off the chart today.
• But in the end, it may be helpful to remember that the stock market is not the economy.

Even if the main driver for the market gyrations these past few days lies squarely in Europe, the US government is far from blameless.  There are real, grown-up ways to deal with the continued economic instability, and real steps that could have been taken to fortify our domestic economic situation while we brace for the inevitable from Europe.  And yet, Congress has consistently shied away from taking such steps over the past 3+ years.  One view, from the Economist:

[The US government's] prescription for a weak economy [through the debt deal] is a large slug of austerity. Thanks to the expiry of a payroll-tax credit and extended jobless benefits in December, the United States is on course for a fiscal contraction of some 2% of GDP next year, the biggest of any large economy—and enough to drag a weak economy into recession.

The debt deal, which implies only modest new spending cuts in the short term, is not directly responsible for this. But Congress could, and should, have stopped this potentially ruinous trajectory. There was a deal to be had: keep up spending in the short term, with a stress on much-needed infrastructure investment, as well as extending the temporary tax cuts, in exchange for a big medium-term reduction in the deficit, centred on entitlements and tax reform. Congress did precisely the opposite, failing to support the economy now and failing to find enough cuts over the next decade to stabilise America’s debt.

Worse, the poisonous politics of the past few weeks have created new sorts of uncertainty. Now that the tea-partiers have used default successfully as a political weapon, it will surely be used again. The refusal to compromise, rapidly becoming a point of honour for both parties, is wreaking damage ... At best, the politicians will have slowed a sputtering expansion; at worst they will have killed off the recovery and inflicted lasting harm on the world’s most impressive prosperity machine. (emphasis added)

Kady is back from a self-imposed sabbatical and may be persuaded to occasionally pop back on her other blog.