rating downgrade does not portend the end of the world. While we do not dismiss the significance of a downgrade from AAA to AA, that would still leave the US credit rating (according to S&P) with a “VERY STRONG capacity to meet its financial commitments…and it differs from the highest rated obligors only in small degree.”
Furthermore other countries that in the past have lost their AAA and dropped to AA, such as Canada, Australia and Japan seem to have been only marginally impacted. More importantly, Canada and Australia were able to regain their AAA rating after several years of fiscal discipline.
But a key question in many investors’ minds is what impact will a downgradehave on interest rates. Taking Japan as an example the answer is that a downgrade may have no impact on rates. Indeed, Japan was downgraded by S&P from AAA to AA+ on February22 2001 and the 10-yr rate moved 24bps lower the following week.
Similarly when both S&P and Fitch lowered Japan’s credit rating to a AA in November of 2001 the 10-year rate traded relatively flat to lower in the weeks following the downgrades.
Ten years have passed since Japan lost its AAA rating and while its 10-year yield still remains close to 1% its currency has not been negatively impacted, but rather it is near the strongest levels of the decade.
Therefore while a credit downgrade would create a long period of uncertainty before all the implications became clear, there is precedent to suggest that rates may be not spike higher as some market participants are expecting and the world’s reserve currency may remain unaffected.
