Downgrade Day: What It Will Look Like

The once-unthinkable is now looking more like all-but-inevitable: the United States is probably going to lose its top-notch credit rating.

And make no mistake: the economic impact should the country be stripped of its coveted triple-A rating will be swift and severe. Stocks and bonds will likely tumble and interest rates will jump higher.

There will be no lag time between the downgrade announcement and when the shock waves begin to be felt.

It starts instantaneously, said Greg McBride, senior financial analyst at You wont be able to grab a cup of coffee before the selloff gets underway.

All of the big three credit rating firms Standard & Poors, Moodys Investor Services and Fitch are threatening to downgrade U.S. debt if Congress fails to address the massive debt load and budget deficits that imperil this countrys long-term financial stability.

With the bickering in Washington, D.C., reaching a fever pitch this week there is growing sentiment that a downgrade is imminent.

Initially, the ratings firms tied their threats to the growing potential for a government default if the U.S. debt limit isnt raised by Aug. 2. But the endless arguing and seeming lack of direction among political leaders is widely believed to have increased the chances for a downgrade, separate from the risk of default.

McBride said the broad ripple effect would be felt immediately. It would unsettle financial markets and it wont be limited to bonds markets, he said.

In a nutshell, heres how it would play out. U.S. Treasury bonds have historically been viewed as the safest of all investments. If the U.S. credit rating is downgraded, U.S. issued debt in the form of Treasury bonds would instantly be considered riskier and thus less valuable.

At the same time, the downgrade would make it more expensive for the U.S. to issue debt because the Treasury will have to pay a higher interest rate to those investors who purchase the bonds.

And the downgrade wouldnt only affect U.S. Treasury bonds. It would affect an array of bonds directly linked to the U.S. government, including state and municipal bonds, and even some corporate debt issued by banks that hold a lot of government securities.

The moment it becomes more expensive for the U.S. to issue debt via higher interest rates it will also become more expensive for those other government entities to issue debt.

Heres how the big investment firm BlackRock (NYSE:BLK) explained it: It is important to note that Treasuries serve as the risk-free rate upon which all valuation models are used to build on other premiums, such as liquidity, volatility, credit quality, etc& Once the risk-free concept is dulled, the implications for modeling other 'riskier' assets becomes significantly more difficult, and consequently financial markets become much more inefficient for virtually all issuing entities.

Also affected would be bond mutual funds, money market funds and pension funds, all of which are frequently subject to requirements that they hold only the highest quality debt, which often means triple-A-rated government bonds.

If those entities are forced to sell off their holdings of U.S. debt because its been downgraded below triple-A it could trigger a significant global sell off in everything, said McBride.

Commodity markets would also be impacted. Higher interest rates would further crimp economic growth, pushing commodities prices lower.

The initial 24 to 48 hours would see a wave of fear and uncertainty and money will come out of commodities, said Darin Newsom, senior analyst at Telvent DTN in Omaha, Neb.

Gold, often considered the ultimate safe haven during difficult times, would be a likely target for a lot of that money, Newsom predicted.

Gold, which hit a new record high of $1,625 an ounce on Wednesday, has been soaring to new highs almost daily as the global economy has lagged and Washington remains at a stalemate.

I would be personally offended as a U.S. citizen that weve let our house get so far out of kilter that it would necessitate a downgrade. However, I do think the fact of the matter is were gonna get one if not now then later at some point, said Peter Kenny, managing director at investment firm Knight Capital Group in Jersey City, N.J.

But Kenny believes the stock markets have already priced in a downgrade. Besides, corporate earnings have been boffo for months, and that isnt going to be affected by a downgrade, he said.

Markets are driven by earnings, Kenny said, and weve gotten those in spades.

Leonard Lardaro, an economics professor at the University of Rhode Island, said the ratings agencies will likely use the utmost caution before downgrading the U.S. credit rating.

I really think that the rating agencies will be looking over their shoulders before they do a downgrade, he said.

In the first place, the rating agencies poised to make this momentous decision are the same firms that performed so badly in rating subprime mortgages during the run-up to the housing bubble last decade. With that track record, which of the firms wants to be the first to downgrade the U.S.?

Do you want to be the one who pulls the trigger? Lardaro asked rhetorically. I think theyve got to be very careful.

Some perspective is needed, according to Lardaro. For instance, everyone agrees the U.S. is deeply in debt and the politicians in Washington are paralyzed. Still, Lardaro asked is the U.S. less credit-worthy than either France or Canada? I think were as credit worthy if not more so.

Given that premise, Lardaro took a counterintuitive view of a downgrade. If a U.S. downgrade spreads across the globe rocking markets worldwide, everyone elses debt will look even worse than U.S. debt. (Europes hardly in better shape than the U.S. right now.) Consequently, investors might view U.S. Treasuries as attractive despite the downgrade.

It wouldnt be that were beautiful, but we would be less ugly than some of the other alternatives, said Lardaro.