Is the US's Credit Rating in Jeopardy?

Credit is the life blood of the American economy. For those who previously could not afford fast cars, big houses, and some bling-bling, credit gives them a chance at the American dream. This credit is made possible through consumer loans, mortgages, and credit cards.

On a larger scale, credit and debt takes the form of treasury bonds and bills. Since US is the largest economy in the world, its bonds are considered "risk-free". This perception is quantified through the use of a credit rating system. The US sovereign credit rating currently stands at the highest possible level at Aaa and AAA. This credit rating has been given by Moody's Investors and Standard & Poor, respectively.

The current economic crisis faced by the US has pushed economists to question this long standing belief. Should the US's credit rating be downgraded?

Last week, the S&P downgraded the outlook on the UK economy, changing it from "stable" to "negative". This downgrade resulted from the UK government's rising debt level, which is reportedly inching closer to 100% of its GDP. A high debt burden naturally corresponds to a higher risk of default or inability to pay off debt. Also last week, Moody's lowered Japan's credit rating two notches to AA, after a prior downgrade from S&P and Fitch's. Japan's poor financial condition and economic outlook rendered it unlikely to pay off its debt, which has reached 170% of its GDP.

One reason why some focus has been shifted to the US is because, like the UK, the US has been incurring large debt. The US government's $787 billion economic stimulus package and $700 billion bank bailout fund pushed the estimate for this year's deficit to a record $1.8 trillion, equal to about 13% of the nation's GDP. Estimates of the deficit continue to skyrocket to more than $2 trillion for 2010, which is a nearly 30% increase in just a few months.

The Obama administration dismissed the possibility of a credit downgrade, saying that the government will continue to do whatever it takes to boost the economy. This belief is shared by many investors, analysts and economists from prestigious firms like JP Morgan Asset Management and Deutsche Bank. Many believe that a credit downgrade will not happen until 2011 at the earliest. In fact, Moody's has said that they are okay with the US's AAA rating.

But what if the US credit rating is downgraded?

A credit downgrade implies that the debt issuer (US government) would be more likely to default on their loans. Therefore, there will be pressure for the US to increase their interest rates in order for investors to be compensated for "extra" risk that they are bearing. In addition, yields on US debt would also rise and existing securities would devalue to match the new higher yields. An increase in the interest rates would undermine the government's stimulus package and the Fed's monetary and quantitative easing measures. Cost of credit will rise for both the government and the private sector, making it harder and more costly for businesses and consumers to borrow money. One of the effects of such event would be slower economic activity.

Furthermore, a credit downgrade will have a large impact on the US's biggest creditors - foreign investors. With large investments in US debts, foreign investors may want to diversify their portfolio and sell off "junk" assets. Investors like China, who have over $1 trillion in US treasuries, may sell part of their holdings and proceed to move their funds to other "safer" assets. Recall that China's officials have already grumbled over the safety of their US investments.

What does this mean for the currency markets?

The effects of a US credit rating downgrade could be pretty big for the currency markets. The perceived value of the US Dollar is already on the decline as the Fed prints money day and night through its quantitative easing measures. If we do see a credit rating downgrade, this will spark less demand for US debt, and as a result, less demand for US Dollars as foreign investors need to buy Greenbacks to get into US assets. Also, investors with large holdings in US assets could sell out of their position, which of course will likely lead to more selling of the Greenback. This could lead to a huge outflow of money from the US Dollar and into other currencies as we are seeing in recent price action. Money has been flowing into gold, oil, and commodity currencies (Australian Dollar and Canadian Dollars), and that flow could get stronger with this event.

While the likelihood of a US credit rating downgrade may be far off as some "experts and analysts" say, the possibility of such a significant event is something to watch out and be ready for. Whether you are a short term or long term trader, the market reaction after a US credit rating downgrade could have a huge positive, or negative, affect in your bottom line. Stay frosty my friends!