S&P's Warning: Ho-Hum

Stock markets this week shrugged off Standard & Poor’s dire warning of an imminent downgrade of the U.S. credit rating as if it was so much celebrity gossip.

The dollar is another story.

After an initial pullback Monday following the release of the S&P report, which lowered the credit rating firm’s outlook on U.S. debt from “stable” to “negative” and issued a pointed threat to America’s AAA rating, bullish equity investors returned to the markets en masse.

Traders evidently viewed the report as fleeting “headline news,” little more than a hypothetical and one a long way out on the horizon.

“It caused some knee-jerk panic on Monday. People took a step back. But it didn’t change people’s opinion of their market strategies,” said Michael James, managing director of equity trading at Wedbush Securities in Los Angeles.

Why not? An influential credit rating firm had warned that unless the U.S. gets its fiscal house in order by 2013, S&P would do what was once unthinkable: cut the U.S. credit rating and codify what many already believe -- U.S. debt is no longer one of, if not the, safest investments in the world.

The reality, however, is that there’s almost no chance that the U.S. will ever have trouble paying back its debts. That’s because, unlike private corporations like Lehman Brothers or Worldcom, two giant U.S. companies forced into bankruptcy in recent years, the U.S. can simply print as much money as it needs to cover its obligations.

Paul Brodsky of QB Asset Management said the real threat to the U.S. is not that it won’t be able to pay its bills but rather the rise in a “perception” that the U.S. can’t pay its bills. In other words, a loss of confidence among global investors that the U.S. can keep its crown as the world’s leading economy.

S&P didn’t help that perception on Monday.

“It’s all about the perception, and the perception is bad if an influential credit rating agency says it’s not 100% guaranteed that the U.S. can repay its debts, which is essentially the message of a credit rating downgrade,” he explained.

Holders of U.S. debt will get repaid, according to Brodsky. The question is whether the money with which they are repaid is worth as much as the money they lent to the U.S.

“I think it’s impossible for the U. S. to default -- literally impossible for the U.S. to default -- because the (Federal Reserve) can print the money with which to repay Treasury debts,” he said.

But the price of that fiscal flexibility -- critics might call it smoke and mirrors -- is inflation.

“We could all repay all our debts that way,” said Brodsky. “But all it does is inflate away the purchasing power of our currencies.”

It’s pretty simple actually. If the U.S. finds a few years from now that it doesn’t have enough cash to pay its debts and resorts to printing more cash to cover those debts, the value of the money it prints, as well as the money already in circulation, declines. It’s just supply and demand: if there’s more supply of something its value declines.

Many economists believe the U.S. is already experiencing just such a phenomenon as a result of the Fed’s unprecedented actions in the wake of the recent financial crisis. In addition to slashing interest rates to a range of 0% to 0.25%, the Fed’s policy of quantitative easing has essentially pumped nearly $3 trillion of    U.S. currency into the global marketplace in an effort to jump start the ailing U.S. economy.

Now, as inflation concerns have risen, investors are pouring money into hard commodities such as oil and gold. A barrel of oil hit $112 on Thursday, the highest level in nearly three years, while gold, the most popular inflation hedge in the history of investing, is at an all-time high of more than $1,500 an ounce.

All of this is already putting pressure on the value of the U.S. dollar, pushing it to its lowest exchange rate against other major currencies since the beginning of the financial crisis in August 2008. Already slipping against the Euro ahead of the S&P report, the credit agency’s warning added momentum to a growing sense of unease that U.S. fiscal policy isn’t helping the largest economy in the world recover from the worst economic downturn since the Great Depression.

Which brings us back to S&P’s threat to cut the U.S. credit rating by 2013 if no credible plan is in place to cut soaring budget deficits. Should S&P pull the trigger, ultimately forcing the Fed to print more money to cover its obligations, analysts say a sustained period of aggressive inflation would likely follow the devaluation of the dollar as the Fed’s newly printed money flowed through the global economy.

But, all of that remains hypothetical -- and way off on the horizon. Stock traders clearly aren’t concerned yet.