Last month, ratings agency Standard & Poor's downgraded the outlook on U.S. Treasuries from "stable" to "negative." What does this mean? For the U.S., it's not good news. Although the country has maintained its 'AAA' credit rating, the outlook downgrade indicates that the ratings agency is dubious of the U.S. government's ability to meet its debt obligations. A full downgrade, should it occur, would mean a lower credit rating for the U.S. and would result in increased borrowing costs for the government. But as the news surrounding federal government debt intensifies, just how bad is this outlook downgrade and what does it mean for the U.S. economy? Here we examine the downgrade and what it might mean for the economy. (Learn more about how rating agencies assess the quality of debt in Why Bad Bonds Get Good Ratings.)

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Why the Downgrade? Why Now?
Was this downgrade a political tactic to get bipartisan agreement to move forward with a plan to control the deficit? Was it a shot at the U.S. government - perhaps one meant to show that S&P has the power to move markets and influence political decision-making, or at least speed things up? Or was it a show of power to convince the U.S. government that it should not prosecute S&P, which has often been cited as a contributor to the economic debacle?

According to the S&P statement, the main reason for the downgrade in the outlook was because of political gridlock over the plan on how to get the deficit under control. If S&P intended on lighting a fire to get politicians to move forward on this issue, the plan seems to have worked. According to S&P, the political differences on any viable plan are very wide and they do not see any progress toward a possible solution. But Moody's, one of the other two rating agencies, opined that the progress of the debates are evidence that things are moving in the right direction.

What Does It Mean?
The downgrade officially means that there is a small chance that the U.S. government's debt rating will be downgraded from 'AAA' at some point in the next six months to two years. Keep in mind that a downgrade does not necessarily mean the U.S. will default, but it will increase the cost of borrowing for the U.S. government, and make borrowing costs higher for consumers and businesses across the country. That said, there is technically a possibility of a government default on July 8 if the debt ceiling is not raised. In this light, the outlook downgrade may not go far enough.

As a result, the outlook downgrade is puzzling. After all, the S&P also gave 'AAA' ratings to mortgage-backed securities until those securities all but vanished. It would have been nice if they had given investors an outlook downgrade on three months before they blew up. At least some investors would have been able to get out. (For background reading, see What Happened To The MBS Market?)

In a quote for a article titled "S&P's Negative Call Stems from Crisis That Some Say it Caused," Barry Ritholz of Big Picture Blog blasted the S&P, saying, "If ever there was an organization more corrupt, incompetent, and less capable of issuing an intelligent analysis on debt than S&P, I am unaware of them!"

Stephen Weiss of Short Hills Capital was also quoted, saying, "I truly find it beyond comprehension that their opinion can move markets when they have done nothing to earn that power. Their most important role is that of insurance policies for portfolio managers who do not have the capability or desire to do their own analysis." (Credit rating agencies have a long history in this country. Learn about what they do and how were they developed. See A Brief History Of Credit Rating Agencies.)

The Market Reaction
While a rating downgrade will cause borrowing rates to increase, the 10-Year Treasury note actually rose on the news. Clearly, some investors still have confidence in U.S. debt.

Overall, S&P's outlook downgrade is both confusing and frustrating. And what does the market think? So far, the impact on the market's demand for Treasuries has been negligible. Yawn ... did S&P say something?

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