What is the rationale behind stock markets retreating due to S&P having a negative outlook on the USA?

Question

From a Bloomberg article published on 18/4/2011

Standard & Poor’s put a “negative” outlook on the AAA credit rating of the U.S., citing a “material risk” the nation’s leaders will fail to deal with rising budget deficits and debt.

• Many of the major indices retreated today because of this news. Why? How do the rising budget deficits and debt relate to the stock markets?

• Why is there such a large emphasis on the S&P rating?

Also, it was stated in the article

The Treasury Department projected that the government may reach the $14.3 trillion debt ceiling limit as soon as mid-May and run out of options for avoiding default by early July.

• Does this have any major implications for the US stock markets today, in the short term and in July?
• What happens when the debt ceiling is reached?

Answer 1

When people (even people in the media) say: "The stock market is up because of X" or "The stock market is down because of Y", they are often engaging in what Nicolas Taleb calls the narrative falacy. They see the market has moved in one direction or another, they open their newspaper, pick a headline that provides a plausible reason for the market to move, and say: "Oh, that is why the stock market is down". Very rarely do statements like this actually come from research, asking people why they bought or sold that day. Sometimes they may be right, but it is usually just story telling. In terms of old fashioned logic this is called the "post hoc, ergo proper hoc" fallacy.

Now all the points people have raised about the US deficit may be valid, and there are plenty of reasons for worrying about the future of the world economy, but they were all known before the S&P report, which didn't really provide the markets with much new information. Note also that the actual bond market didn't move much after hearing the same report, in fact the price of 10 year US Treasury bonds actually rose a tiny bit.

Take these simple statements about what makes the market go up or down on any given day with several fistfuls of salt.

Answer 2

Many of the major indices retreated today because of this news. Why? How do the rising budget deficits and debt relate to the stock markets?

The major reason for the market retreating is the uncertainty regarding the US Dollar. If the US credit rating drops that will have an inflationary effect on the currency (as it will push up the cost of US Treasuries and reduce confidence in the USD). If this continues the loss of USD confidence could bring an end to the USD as the world's reserve currency which could also create inflation (as world banks could reduce their USD reserves).

This can make US assets appear overvalued.

Why is there such a large emphasis on the S&P rating?

S&P is a large trusted rating agency so the market will respond to their analysis much like how a bank would respond to any change in your rating by Transunion (Consumer Credit Bureau)

Does this have any major implications for the US stock markets today, in the short term and in July?

If you are a day-trader I'm sure it does. There will be minor fluctuations in the market as soon as news comes out (either of its extension or any expected delays in passing that extension).

What happens when the debt ceiling is reached?

Since the US is in a deficit spending situation it needs to borrow more to satisfy its existing obligations (in short it pays its debt with more debt). As a result, if the debt ceiling isn't raised then eventually the US will be unable to pay its existing obligations. We would be in a default situation which could have devastating affects on the value of the USD.

How hard the hit will depend on how long the default situation lasts (the longer we go without an increased ceiling after the exhaustion point the more we default on).

In reality, Congress will approve a raise, but they will drag it out to the last possible minute. They want to appear as if they are against it, but they understand the catastrophic effects of not doing so.

Answer 3

Many of the major indices retreated today because of this news. Why? How do the rising budget deficits and debt relate to the stock markets?

It does seem strange that there is a correlation between government debt and the stock market. But I could see many reasons for the reaction. The downgrade by S&P may make it more expensive for the government to borrow money (i.e. higher interest rates). This means it becomes more expensive for the government to borrow money and the government will probably need to raise taxes to cover the cost of borrowing. Rising taxes are not good for business. Also, many banks in the US hold US government debt. Rising yields will push down the value of their holdings which in turn will reduce the value of US debt on the businesses' balance sheets. This weakens the banks' balance sheets. They may even start to unload US bonds.

Why is there such a large emphasis on the S&P rating?

I don't know. I think they have proven they are practically useless. That's just my opinion. Many, though, still think they are a credible ratings agency.

What happens when the debt ceiling is reached?

Theoretically the government has to stop borrowing money once the debt ceiling is reached. If this occurs and the government does not raise the debt ceiling then the government faces three choices:

1. Raise taxes
2. Default on debt payments
3. Reduce spending

Answer 4

If you spoke in front of a group of people in 2001 about the possibility of be lowered, you would be written off as a kook. Now S&P is talking about a negative credit outlook -- scary stuff.

It's scary because a base assumption in any risk model is that US Treasury debt is utterly reliable and comes with zero default risk. So publicly banding about the notion that US Treasury debt may be less the AAA in two years is a shock to the system and changes the way many people assess risk. It's also scary because Treasury debt is auctioned... will a spooked market still accept a measely 2.9% return for a 7 year T-Bill?

But while the prospect of a credit downgrade is truly a bad thing, you also need to take the S&P statements with a grain of salt -- since being a named a villain during the mortgage implosion (these were the guys who declared junk mortgage securities as AAA), they now err on the side of doom and gloom. So while things are bad, they've been bad since the Bush administration was forced to put Fannie Mae & Freddie Mac on the government balance sheet to stave off a bank panic.

The scary stuff about default in July due to the debt ceiling debate is not very credible at all. Unless the Republican House plans on dramatically slashing spending on Medicare, Defense or Social Security and have the votes to stick to that strategy, the debt ceiling will be raised after much ado. Politicians talk tough, but have a proven track record of creating financial problems tomorrow to fix electoral problems today.

Answer 5

I think a big part of the issue is ignorance. For instance, the US govt cannot default on its loans, yet you keep hearing people speak as if it could. The US govt also does not have to borrow to pay for anything, it creates its own money whenever it wants. These 2 facts often evade many people, and they feel the US govt should act like a household, business, or a state govt. This disconnect leads to a lot of confusion, and things like "fiscal crisis". Just remember Rahm Emanuel - don't let a crisis go to waste.

Disclaimer: this is not to say the US should create money whenever it wants without thought. However, the simple fact is it can. For those interested in more, check out Modern Monetary Theory (MMT). Its economic study in a world not based on gold standard, or convertible currency (fiat currency).