S&P Downgrade Doesn't Make Sense


The S&P downgrade is a unique occurrence in the annals of finance: A storied institution puts its credibility at risk, unnecessarily, to make controversial statement of deep conviction.

While I applaud the principle, I wish the McGraw Hill-owned (NYS: MHP) Standard & Poor's had reserved such chutzpah for a more deserving cause. Here's why.

The U.S. can't default
The basic problem with S&P's decision is that it's not true. A credit grade is supposed to reflect the probability of default, and the probability of our country defaulting on its debt is exactly 0. The U.S. cannot default -- unless we want to, and last week's vote shows we really don't.

You may be asking, "Chris, if we continue to spend beyond our means, won't we eventually have to default?"

No. This is because U.S. bonds are obligations to payback a fixed quantity of dollars. Therefore we can always print more dollars to meet our obligations. The U.S. can never default unwillingly.

As Warren Buffett told Fox Business News, "Think about it. The U.S., to my knowledge owes no money in currency other than the U.S. dollar, which it can print at will. "

And Buffett is putting his money where his mouth is: Berkshire Hathaway (NYS: BRK.A) (NYS: BRK.B) , he announced, will continue to hold more than $40 billion of short-duration T-bills and that he views them as "quadruple A."

I also doubt Moody's (NYS: MCO) will downgrade after seeing their largest investor's quizzical reaction.

"But Chris, if the U.S. has to print dollars won't that lead to inflation? Isn't that a de facto default?"

Inflation is a separate risk from credit risk. Inflation doesn't just affect Treasuries but all bonds denominated in dollars, including U.S. corporate and municipal bonds. It's a risk priced in independently of credit risk.

If S&P is trying to say that investors in Treasuries are going to get their purchasing power destroyed, that is akin to saying that Treasuries are overpriced. But it's not the job of a credit rating agency to say whether a bond is correctly priced, only whether the issuer can meet its obligations. And since U.S government obligations are dollar denominated, we always can.

"OK, Chris, but if we continue to spend like drunken sailors, won't the credit market eventually wake up and refuse to lend?"

Therein lies the fear, that the credit market will see inflation coming and refuse to lend at anything less than usurious rates. This is the sole reason to worry about the deficit.

But right now, investors are seemingly afraid of everything but inflation. The U.S. government can borrow money at 3.8% for 30 years. Evidently, what investors are afraid of is how fragile the economy is, something the S&P downgrade can only make worse.

What to expect
Typically when an issuer has its credit downgraded, its bonds fall in price so that its yields increase, thereby pricing in greater risk.

If I were a betting man, however, I'd say just the opposite will happen in this unusual case.

You see, Treasuries occupy a weird Twilight Zone place in capital markets. They are expected to be the "risk-free asset," or the asset that is less risky (if held to maturity) than any other.

So, paradoxically, the uncertainty generated by S&P's downgrade may fling investors into the arms of the rebuked asset-Treasuries.

I'd watch to see how interest rate sensitive Treasury ETFs like iShares Barclays 20 Year Treasuries (NYS: TLT) and iShares Barclays 7-10 Year Treasury (NYS: IEF) perform. My bet would be they'll go up in price.

The real fun will be watching how gold and the SPDR Gold Trust (NYS: GLD) perform over the following weeks. My guess would be that gold will go down in price despite its marketing as a "safe-harbor" asset: As gold gets more into the hands of traditional retail investors, its price will follow what most retail investors (unfortunately) do -- sell when things get scary and buy when things aren't.

As for equities, the market could interpret this in three different ways:

1. "Yay, S&P finally got it over with. And we agree that all bonds, including Treasuries, are a pretty bad bet right now with inflation possibly coming down the line, so better buy stocks instead!"

2. "Oh no, Treasuries are going to go down, and therefore stock prices (whose earnings yields are compared to those available on Treasuries) are going to go down, too. Better sell."

Or my personal favorite:

3. "Congress may actually cut spending. Which is bad for employment and bad for stocks. Better sell."

The third case is the most likely if stocks go down but Treasuries go up today.

Regardless of how the market reacts, I think it's important to be keep calm and carry on.

If you liked stocks on Friday, you should love them after today.

Fool contributor Chris Baines is a value investor. Follow him on Twitter @askchrisbaines. Chris's stock picks and pans have outperformed 90% of players on CAPS. Chris owns shares of Berkshire Hathaway. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

At the time thisarticle was published

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