U.S. Credit Downgrade By S&P Darkens Economic Outlook, Stokes Recession Fears

NEW YORK -- With the United States government now shorn of its top credit rating by Standard & Poor's, experts are increasingly worried that the American economy is headed back into recession, while Europe appears vulnerable to another shock.

The announcement that the rating agency had reduced the U.S. government's AAA rating for the first time in history came after days of punishing declines in the stock market, and has now cast a shadow over economic prospects in the months ahead. A recent stream of indicators has provoked concern that the economy could be headed for another recession, with the growth rate slowing considerably, unemployment stubbornly elevated and the stock market swooning. Some experts say the downgrade could be the final trigger, making credit more expensive and sowing broad unease.

"People will be pulling money out of equity markets, out of commodity markets, and putting it into cash -- essentially, stuffing money in your mattress," said Andrew Lo, a professor of finance at the MIT Sloan School of Management, in an interview Saturday. "This is the worst thing to have happened, given the weak economy we already have."

"Some straw has to break the camel's back," he added. "This may be the straw."

The psychological impact of the downgrade might cause stocks to fall Monday and could exacerbate the sovereign debt crisis in Europe, experts say. Over time, it could raise the interest rates on 10-year and 30-year Treasury debt, making it more expensive for the federal government to borrow money, further worsening the deficit. The downgrade could also push up the cost of loans that are tied to the Treasury rate, making it more expensive for Americans to get funds to buy a car or a house.

The effects could reach Europe, where nations that share the euro currency are contending with a debt crisis that seems to deepen by the week. While S&P didn't announce plans to reduce the ratings of European countries following its U.S. Treasury downgrade, experts said European downgrades might be inevitable, to maintain consistency in the rating system. That in turn could spark a new round of panic.

S&P's decision comes at a time of critical economic weakness, as the American economy seems increasingly vulnerable to another contraction just two years after the official end of the recession that began in December 2007. Gross domestic product grew at an annual rate of just 0.85 percent in the first half of the year, the government announced in July. Seen in relation to population growth, GDP actually shrank in the first three months of the year.

After other data releases showed the manufacturing sector weakening and consumer spending drying up, the Dow Jones Industrial Average lost 513 points on Thursday, in the biggest one-day drop since the depths of the financial crisis.

It remains unclear what the precise effects of S&P's downgrade will be, or when they might materialize. Some experts believe the global economy will be able to absorb the downgrade without much turmoil. But others, like Lo, take a more pessimistic view.

S&P laid blame for its decision to assign the AA+ rating directly on the political process in Washington. Even though lawmakers reached a decision on Aug. 2 to raise the government's debt ceiling and avoid a potentially disastrous default, the deficit-reduction package that accompanied the deal won't sufficiently improve the government's fiscal health in the coming years, S&P said in a release Friday. A factor in that projection, S&P said, is that Republicans seem unwilling to allow the Bush-era tax cuts to expire.

"The majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act," S&P said.

The ratings agency said political dysfunction provoked the downgrade, noting that Congress seems to lack the ability to aid the weakening economy. And now, as S&P acknowledged, the downgrade might introduce a new source of strain.

"The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed," the company said. "The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy."

Although interest rates on long-term U.S. Treasury debt might rise as a result of the downgrade, rates on short-term debt could fall, as investors throw money at safe-haven assets. The yields on Treasury bills, which have the shortest lifespans of the government's debt securities, could fall below zero, if investors turn to U.S. debt that is keeping its rating intact.

Interest rate movement in bond markets, moreover, might be minimal at first. Investors' attitudes about the economy influence their demand for Treasury debt; with the outlook grim, investors have been fleeing from risk, eager to lend money to the U.S. government and happy to accept low compensation. Yields on 10-year Treasury notes neared 2.4 percent, a low not seen since last fall, as the Federal Reserve was beginning a second massive economic stimulus.

But over the next few years, yields on a variety of investments that are influenced by the Treasury rate might rise, implying that a whole range of assets would be treated as riskier.

"When there's more demand for credit, that's when we're likely to see a re-pricing of risk," Mark Vitner, a senior economist at Wells Fargo, said Saturday. "In the very near term, our borrowing costs are going down, due entirely to economic weakness."

In the coming week, the downgrade could cause a period of selling, as investors shun risk. Stocks, commodities and the U.S. dollar might all take hits in the coming days, experts said.

Over time, a downgrade could increase the federal government's cost of borrowing by $100 billion a year, said Terry Belton, global head of fixed income strategy at JPMorgan Chase, in a conference call last week.

As the federal government reduces spending, the fiscal health of states and localities could suffer. Many cities depend on states for aid, and some states in turn depend on the federal government. If those governments face increased strain over the coming years, their credit ratings could also be vulnerable.

In a July report, S&P said there are certain ratings that "move in lockstep" with the U.S. sovereign rating. Those include home loans backed the federal government and the debt of government-related entities. The mortgage giants Fannie Mae and Freddie Mac might see their ratings docked.

And more sovereign downgrades could follow, experts said.

"If the U.S. Treasury is not AAA, it's hard to justify anyone else being AAA," said Matt Fabian, managing director of the Concord, Mass.-based Municipal Market Advisors, in an interview Saturday. "France, or Microsoft, or some of the muni issuers like Utah or North Carolina -- it's hard to see them as AAAs if the feds aren't."

With a crisis building in Europe, sovereign downgrades on the continent could push markets to a breaking point, said Lo, of MIT. Borrowing costs for the economically weaker nations that share the euro have skyrocketed in recent weeks, with jittery investors fearful of widespread panic. On Thursday, a subtle implication in an announcement from the European Central Bank was enough to spark a temporary sell-off of Italian debt, and cause a plunge in the Italian stock market.

If S&P does not downgrade other governments, the logic of its rating system might fall apart, Fabian said.

"They would just be accelerating the demise of ratings," he said in an interview late last month. "They are reducing the utility of their own product."

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