There was no panic, but there was certainly some pain. As the soap opera of debt-ceiling talks plays out in Washington, Wall Street finished Friday with its worst weekly performance in more than a year, signaling that investors are bracing for the possible repercussions of a government default—or, perhaps more likely, for a downgrading of the federal government’s long-held AAA credit rating.
The Dow Jones Industrial Average, which had been off by 156 points in the morning, ended the day off 96.87 points, or 0.79 percent, at 12,143.24. The index has fallen for six straight sessions and lost 4.24 percent on the week. The Standard & Poor’s 500-stock index slid another 8.39 points, or 0.65 percent, making for a 3.9 percent loss on the week.
The concern for investors and consumers now, both here and abroad, is whether the pain will continue. In speaking about the debt talks Friday morning, President Obama again touched on the potential impact of a ratings downgrade. “Make no mistake, for those who say they oppose tax increases on anyone, a lower credit rating would result potentially in a tax increase on everyone in the form of higher interest rates on their mortgages, their car loans, their credit cards. And that's inexcusable.”
A lower rating could lead to higher interest rates for government borrowing, potentially tacking on $100 billion in added costs, Terry Belton, global head of fixed income strategy at JPMorgan Chase, told reporters this week during a conference call organized by the Securities Industry and Financial Markets Association. And with interest rates on many types of consumer debt tied to the government rate, a downgrade of the nation’s AAA credit rating could have far-ranging ripple effects. “Any increase in that rate has a ripple effect through other markets that use Treasuries as a reference or benchmark,” says Jim Caron, head of global interest rate strategy at Morgan Stanley.
Yet many economists and market-watchers believe that risk-wary investors, even if unnerved by the fragility of the economic recovery and the uncertainty surrounding a ratings downgrade, would still opt to buy U.S. Treasuries, minimizing any turbulence.
Here, a look at how the debt-ceiling drama and a likely credit-rating downgrade might affect a number of asset classes:
Stocks: Even as the economic recovery falters, corporate profits have stayed strong, and stocks have followed. The Dow Jones Industrial Average is up 16 percent over the last 52 weeks, and the S&P 500 has gained more than 17 percent. But a spike in interest rates would create a drag on corporate earnings, potentially eroding those recent gains, and spooked investors could send stocks tumbling. “It may be a function of how long the markets expect it will take for politicians to get their acts together,” says Dr. Harm Bandholz, chief U.S. economist at UniCredit.
Treasuries: “While a downgrade to double-A for the U.S. will certainly be an embarrassment, it is unlikely to have a meaningful impact on Treasury yields,” wrote Citigroup’s head of asset-allocation research, Amitabh Arora, in a research note published last Friday. A downgrade of U.S. debt would not necessarily cause a long-term jump in interest rates. “The knee-jerk reaction may be that Treasury yields go up a bit,” says Jim Caron, head of global interest rate strategy at Morgan Stanley. But as President Obama noted Friday morning, any downgrade would come “not because we didn't have the capacity to pay our bills – we do – but because we didn't have a AAA political system to match our AAA credit rating.” Ultimately, jittery investors looking for safe places to stash their money might not be scared away for long. “At the end of the day what happens to yields is really a question of what happens to other risky assets,” Caron says, and it could turn out that “Treasuries are still the best house in a bad neighborhood.”
The dollar: The greenback has fallen to a four-month low against the yen and is near record lows against the Swiss franc. The dollar could actually see a short-term boost from a credit downgrade, as investors seek to minimize their risk. But a ratings cut, particularly if its paired with continued struggles for the economy, would likely mean further long-term weakness against those safe-haven currencies. “The most straightforward outcome would be a drop in the dollar against the yen,” says Bandholz. Currencies such as the Australian and Canadian dollars may also continue to benefit from weakness in the U.S. currency, says Caron.
Money market funds: Institutional investors have already begun shifting their money out of money market funds that buy Treasuries and other securities regarded as ultra-safe, according to data released this week by the Investment Company Institute. The outflows from institutional money market funds totaled nearly $38 billion, higher than seasonal norms, but institutional investors still have more than $1.7 trillion in such funds, with retail investors holding another $919 billion. The recent outflows suggest investors may be looking to avoid any risks associated with a possible government default or downgrade and are looking instead for even safer places—like bank checking accounts—to keep cash. “I don’t know of any scenario in which money market funds would be disproportionately affected compared to other market participants by a failure to raise the debt ceiling,” ICI Chief Economist Brian Reid wrote in a note posted on the group’s website Thursday. “But, like all others in the asset management business, money market fund managers are preparing for market volatility that could arise if Congress doesn’t act. Managers are making their funds more liquid and turning to shorter term instruments to prepare.”
Gold: The traditional safe haven investment has surged nearly 40 percent over the past year, repeatedly setting record highs, and closing above $1,600 an ounce for the first time on July 18. That run could go on if a weak dollar sends investors scrambling for safety.
Housing: If the government’s credit rating is cut, the AAA status of government-sponsored lending giants Fannie Mae and Freddie Mac would follow, resulting in higher mortgage rates for homebuyers. “The monthly payment on a $200,000 30-year mortgage would increase by a whopping $240 per month if mortgage rates go up slightly from 4.51% to 6.43% like they were just three short years ago,” according to Gibran Nicholas of the CMPS Institute, an organization that trains mortgage bankers. “Even if interest rates only go up by 1 percent it would cost an extra $122 per month.”
Municipal bonds: On Thursday, Moody’s Investor Service placed the Aaa ratings of 177 U.S. municipal bond issuers on review for possible downgrade because of their indirect ties to the federal government’s rating. The roster of affected agencies includes 162 local governments spread across 31 states, with 66 cities, 53 counties and 29 school districts on the list. In all, the warning covers $69 billion in outstanding debt. That follows a similar move by the rating agency last week, in which the Aaa ratings of five states – Maryland, New Mexico, South Carolina, Tennessee and Virginia—were placed under review for possible downgrades. The muni market has taken those warnings in stride. “Despite these ominous portents, municipal bonds have not demonstrated an unusual amount of volatility," UBS analysts wrote this week, in a report cited by Dow Jones. "Rating agency warnings regarding the knock-on effects of a sovereign rating revision have been greeted with some anxiety but pricing has not changed materially."