Three rating agencies S&P, Fitch rating, and Moody analyse the Economics, Financial, stability, and Political indicators of - federal government, provincial/ state governments, Public corporations, Companies, and agencies - who issue bonds. There are three types of ratings
1. Short term, 2. Medium Term, 3. Long Term
At the moment, all three rating agencies have put US short term and medium term rating on watch. There are two types of watch positive or negative. US rating is under negative watch. Rating show how safe it is to invest in given bond or simply the risk of default on given bond ( A issuer can have two different ratings on two different bond issues). A company (government or any bond issuer) with AAA rating is sought to be fully secure with lowest probability to default on its obligations compared to issuer with a BBB or B or C which are considered junk bond - mean high probability to default.
Currently US has highest ratings with Moody and Fitch and today, S&P has downgraded US rating from AAA to AA+ with another negative watch. Moody and Fitch have also put US rating under negative watch.
Now question is how this downgrade will impact the US and global economy?
To understand the issue, we need to understand the interest rate system in economy and importance of rate on bonds.
In countries which use Monetary policy to stabilize economy, central bank normally set the base rate. This rate means no lender will land any money or finance any thing lower than the base rate or fed rate. The higher rate is used to cool down the economy when economy is overheated - high interest rate leads to decline in demand, consumer spending, higher borrowing costs, and increase in saving, I can't explain the cycle here- in case of fragile economic conditions lower rates are used to have opposite effect.
Financial institution borrow from each other or from central bank borrowing window with rate which is little higher than base rate for most creditworthy financial institutions and is known as inter bank rate. The rate is calculated as
Base rate + risk associated with borrower
LIBOR or London Interbank offer rate serves as benchmark for global inter bank landing and changes frequently. LIBOR also serve as bench mark for landing to non-financial institutions.
Before bond rate lets look at some common investments, the return on securities follows like this in descending order
1. Bonds
2. Saving Accounts
3. Commodities
4. Real Estate
5. Stocks or Equities
6. Derivatives
Bonds are considered safest investments available to common public. The expected and current return on bonds is published by number of organizations. Bonds returns is determine by
inter bank rate or base rate + risk (probability of default on given bond)
US bonds had enjoyed most secure AAA rating since 1917, and rate on short term US bonds (know at T-Bill- which are issued with less 90 days maturity) is considered risk free rate in financial markets, therefore these bonds carry lowest return on investment.
Bond rates determine the mortgage, credit card, saving and other public landing and borrowing rates in economy.
A lower US rating means, US government has higher probability to default on its obligation in near future not in long term. This will increase the required return on US bonds this can be done by a selling spree (bond return is calculated as -
[+increase/-decrease in price (selling - buying) + coupon]/buying price
An increase in required return on US bonds will lead to a higher return other sectors of economy. Which will result in high borrowing cost to business and public, this will lead to lower demand and production, more bankruptcies by business as lots of business use line of credits or short term landings to meet their day to day business needs. This situation can lead to increase in unemployment or simply another US recession which will spread globally in small time.
The trading data from global equity markets shows that the financial sector is expecting another recession is near future. This fear is a combination of fears from Euro Zone Debt conditions and US economic conditions.
Question arises, is there other countries with AAA ratings? if yes then why not use them as bench mark?
There are several western countries with AAA rating and Canada is one of them. None of the Asian or African country have this rating. Its not easy to use any other countries rating as benchmark under current economic conditions because
1) Currently Euro Zone countries-which has highest number of countries with AAA rating- are in trouble due to domestic debt issues
2) US normally leads the global demand and received $ 0.60 of any dollar invested the world
3) Why not Canada, Canadian economy is highly dependent on US economy i.e.Canadian manufacturing sector
A downgrade of US bond rating will have very bad impact on global economy. Unemployment is likely to increase as first step, interest rate will increase, and this time Canadian and other governments will not be able to issue stimulus packages due to volume of their budget deficits.
US government is currently explaining the fiscal consolidation recently achieved to all three rating companies, and I am in hope that S&P will raise US ratings and other will not downgrade the US rating. If it occurs then it can be an armageddon, a recession worst then 1987 or 2007 or might be worse then great depression of 1930's.
The rating agencies say that US need approx $ 4 trillion to meet it short-medium term obligations, and a $ 4 trillion in increase in debt ceiling will increase the the government debt which now stands at more then 100% of GDP. Therefore, they are looking for more budget cuts or savings.
Hi zulkfal,