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Federal Government Debt Rating Downgrade Not All Bad

written by: Tim Plaehn•edited by: Michele McDonough•updated: 8/8/2011

Is there a silver lining to the recent downgrade of the U.S. credit rating? The end result of an AA+ rated federal government may not be as bad as the news reports are projecting.

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    S&P Rates U.S. Debt AA+

    Money Links After many weeks of discussion plus the political debate over the federal debt ceiling and spending cuts, one of the rating agencies -- Standard & Poor's -- has officially downgraded the credit rating of the U.S. government from the top rating of AAA down one notch to AA+. The other two major rating agencies -- Moody's and Fitch Ratings -- are currently sticking with a Aaa / AAA rating for the U.S. government.

    Conventional wisdom says a downgrade of a debt rating means the interest rates on the issuer's outstanding bonds will increase, lowering the prices. Also, going forward, the issuer, in this case the U.S. Treasury, will have to pay higher rates to get investors to buy its bonds.However, as of Monday morning following the S&P downgrade on Friday, it is global stock markets which are taking a tumble and the market for U.S. Treasury debt is strong with yields down and prices up. For some reason, the investing world sees a downgrade of the U.S. credit rating as a bad thing for the profits of private companies and a not so bad thing for the actual issuer of federal debt.

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    Effect on Consumers

    Dollars One of the arguments coming from the political class concerning the negative effect of a credit downgrade for the federal government is that it will result in an increase in the borrowing rates paid by consumers. This appears to be one of those arguments someone started without much in the way of research and it keeps spreading because it sounds good to say a bad thing for the federal government must naturally result in pain for the general public.

    The fallacy of this argument is most consumer lending rates are not tied to Treasury debt rates. The major consumer lending index rate, the Prime rate, is directly tied to the fed funds target rate. The fed funds rate is set by the Federal Reserve Board, which sets the rate based on economic conditions. An increasing cost of borrowing for the Treasury will not translate into a higher fed funds rate, and thus a higher Prime rate, so it will not lead to higher consumer lending rates.

    The rate for 30-year fixed rate conforming mortgages is affected by the current yield on the 10-year Treasury note. However, mortgage rates only apply to someone getting a new mortgage for a purchase or refinance. With the 10-year Treasury note currently yielding well under 3 percent even with a AA+ rating, coupled with the problems in the housing markets, significantly higher mortgage rates do not seem to be an issue for the near -- two to three years -- future.

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    Positive for Investors

    Wooden box The credit downgrade of the U.S. Treasury debt may end up as a positive for investors. Fixed income investors have been living with miserably low interest rates since at least 2008. A one-notch lower credit rating may eventually push the rates for medium to long term Treasury securities a little higher. A jump right now into long maturity Treasuries would not be prudent, because bond prices will fall as rates start to increase. At the current point, investors can keep money in short term investments to be ready to pick up higher rates when and if the market starts pricing Treasury bonds like other AA rated securities.

    The biggest positive of the ratings downgrade for federal debt will be if the downgrade is a wake-up call for the government to get its act together regarding revenues, spending and debt. However they decide to get there, the federal government needs to find a new financial path which does not include borrowing nearly $2 trillion per year to pay for all of the budgeted government spending. The near to crashing stock markets may be more of a sign there is no belief in economic recovery without a spending overhaul than a reaction to the actual credit downgrade.

    Individuals and families can view the government credit downgrade as a lesson or sign that now, more than ever, is the time to get out of the borrowing frame of mind and into a savings and building wealth mindset. The easy credit policies which have crippled the U.S. housing market over the last 5 years are being repeated in the house of the federal government. The state of the economy and financial markets will be significantly different over the next several years, and like all periods of upheaval, there will be some excellent investment opportunities.

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    Will the World Dump Treasuries?

    A final note concerns the fear the credit downgrade will cause Treasury bond investors around the world to dump Treasuries or not buy new issues. It is hard to imagine another AAA rated government being able to meet the demand of global investment needs. The U.S. Treasury issued over $8 trillion in Treasury securities in 2010. From this point, the AA+ of U.S. Treasury securities will become the new AAA and countries like China and Brazil will still use Treasury bills, notes and bonds as their preferred investment vehicles.

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