The recent change from S&P on their outlook for the U.S. as a AAA credit begs the question: Is the U.S. a bad credit risk? Although this is an interesting question, and the answer is probably no, like a lot of things in life, the reality is that country risk is not absolute, it is relative – relative to other countries.
Despite the fact that our national debt and budget deficits are enormous, and skyrocketing, we have to compare ourselves to other countries, to evaluate the changing perceptions of U.S. credit risk. In the developed world, basically every country, with the exception of Germany, made the same mistakes we made, that put us into this pickle. Excesses in real estate and the credit markets in general, drove the worldwide economic collapse that resulted in the accumulation of not only huge national deficits, but also personal debt as well.
Even if we break the current debt ceiling, which is a virtual certainty, and even with the very real possibility (probability) that the U.S. credit rating will fall below AAA in the next year or two, the U.S. is still today, and will remain, the strongest economy on the planet, and therefore, to most, the safest place to put money.
While the fact that we will likely remain at the top of the heap economically is somewhat comforting, it does not mean that we will not feel some pain. The reality is that financial markets trade on risk and reward perceptions. If the risk of the U.S. is perceived to increase, as will be the case if and when our credit rating is lowered, the cost to service our debt or take on more debt, will increase. In practical terms, the rates we will need to pay on new bonds issued will have to go up to compensate investors for that perceived increased risk. If we couple this with a rising interest rate environment, which I believe we will be entering shortly, we could have a slingshot effect on the rising cost to maintain our debt and finance future budget deficits.
This scenario is very real, and has lead to the devaluation of many currencies around the globe. We need to watch the value of the dollar closely, since rising inflation will be the trigger that forces the Fed to start the interest rate raising cycle. The more the threat of inflation, the more aggressive the Fed will need to be with rates, and the greater the impact will be on the cost of servicing our debt (and the more negative will be the impact on economic growth as well).