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Week Ahead: Markets Will Sort Through Credit Downgrade

Markets in the coming week will digest the once unthinkable - the downgrade of the United States gold standard AAA rating - and the impact it will have on other credit ratings and investor confidence.

Sandra Baker | Photographer's Choice | Getty Images

The Standard and Poor's one-notch downgrade to AA plus came late Friday, just hours after European officials managed to convince markets they were at least working towards a plan to stop Italy from being sucked down by the credit crisis. The Fed also meets Tuesday, and traders have increasingly been looking for it to restart its extraordinary easing program or take other steps, though Fed watchers doubt such a move.

"I did not expect this (downgrade) to happen this soon. This is something they gave the criteria on and I guess they stuck to it. I really thought they'd take the two stage approach and see how further (spending) cuts would come along," said George Goncalves, chief Treasury strategist for Nomura Americas.

"In the moments in the past when large countries were downgraded, our analysis shows there is some volatility. It depends on the market conditions. I don't think given the environment we're in right now, this was the optimal time to be seeing a downgrade of the largest nation in the world. The only fear I have is that after a pretty rough week in the risk markets, how is this going to be perceived by investors," he said.

What other actions or unintended consequences will follow are yet to be seen. Late Friday, the Fed and FDIC said U.S. banks will not have to increase capital due to the downgrade.

"It's very symbolic. But more importantly, we'll have to see if this will potentially trigger other rating actions, and we'll see what that means on Monday for broader markets," Goncalves said. Moody's and Fitch have both reaffirmed the AAA rating for now, though they have the U.S. on negative watch.

The downgrade also came at the end of a harrowing week for stocks. Equities markets worldwide suffered their worst declines since the financial crisis, as investors shunned risk assets and ran to the safety of cash and Treasury securities.

Marc Pado, Cantor Fitzgerald market strategist, said it may be that stocks will take the news better than some might expect because the market has been reacting to the potential downgrade by one or more notches for the past two weeks.

"Asia's going to open first, and Europe second. There might be more angst in trading there before our markets open. But after the first hour, I think we'll shake it off," he said. "If they were going to take it down more than one notch, we would have a bigger reaction of three to five percent in the market."

Whither Stocks

The stock market selling reached a crescendo Thursday when the Dow fell more than 500 points, leading some investors to wonder whether a moment of capitulation had occurred. On Friday, stocks swung volatility, with the Dow traveling more than 400 points before finishing up 60 points to 11,444.

"This is fairly typical behavior when you're getting close to a bottom. You have a dramatic move down, a lot of volatility," said Ed Keon, managing director at Prudential Financial's Quantitative Management. "..There's no guarantee this is the bottom, but these big whipsaw moves are the kind of things you see."

The S&P 500 lost 7 percent to 1199 in the past week, its worst decline since November, 2008. Goldman Sachs analysts late Friday cut their forecast for the S&P 500 to 1400 from 1450 based on their lowered expectation for U.S. GDP.

Stocks have been rocked in the past two weeks by deteriorating economic news, and also by the loss of confidence in Europe's ability to stop its debt crisis from spreading. The debt ceiling debate in Washington was also a factor, as it generated the specter of the U.S. credit rating downgrade. Rumors circulated Friday that S&P was ready to cut the rating, which added pressure to stocks.

S&P had warned U.S. officials that if they did not cut spending by $4 trillion that the rating was at risk. Congress, which bickered for days, had a difficult time agreeing to cuts of $2.1 trillion.

S&P said part of the reason it downgraded the U.S. was because of the debt ceiling feud in Congress. "You can't have faith in a government that will take until the 11th hour like that," said Pado. "But Congress has to know that this is a warning shot by S&P. They pretty much laid down the law."

Meanwhile, Europe's efforts to stop the sell off in the peripheral sovereign debt, particularly Italy's, will be a key in the coming week. Italian President Silvio Berlusconi Friday announced budget reform measures. In turn, the European Central Bank will now start buying its bonds Monday, according to an Italian official quoted by news wires. The markets were encouraged by the move.

"Next week, there may be a G7 meeting, for the heads of state. Berlusconi seemed to hint at it. That will be a focus from a policy perspective," said Tony Crescenzi, senior strategist at Pimco.

Crescenzi said the Fed, at its meeting Tuesday, may discuss new remedies for the economy's sluggishness but it is not likely to reveal them until the minutes of its meeting are released three weeks later. That will also be about the time that Fed Chairman Ben Bernanke speaks at the Fed's annual meeting in Jackson Hole, where he discussed quantitative easing for the first time.

However, the Fed might be more vocal in its statement Tuesday if financial markets are in disarray.

He said the Fed had been "engaged in so-called watchful, waiting, at least until this past two weeks of events, which now have upended confidence at the CEO level, the consumer level and the investor level. It may be too soon for the Fed to act on a changed climate," he said.

Econo-drama

The Fed's meeting is the big event, but investors will also be watching retail sales and consumer sentiment Friday and weekly jobless claims Thursday. There are other reports worth monitoring, including the NFIB small business survey and productivity and costs Tuesday. Wednesday's reports include the JOLTS, which provides labor market details. Wholesale trade is also reported that day and international trade is released Thursday.

Earnings Central

Earnings news is slowing down but there are still a good number of reports this week. Disney, reporting after Tuesday's bell, and Cisco, reporting Wednesday, are the remaining Dow components yet to report. Retailers also begin to show up on the calendar.

Monday's reports include Tyson Foods, Scotts Miracle Gro, U.S. Cellular, Dollar Thrifty, MGM Resorts and Live Nation. On Tuesday, AOL, Booz Allen Hamilton, Beazer Homes, Dish Networks, Scripps Networks, Sunpower and Liberty Media report.

News Corp, Macy's, Nestle, Polo Ralph Lauren, Advanced Auto Parts and Computer Sciences report on Wednesday. Anheuser Busch InBev, Tim Horton, Wendy's, Kohls, Nordstrom, Nvidia and DeVry release results Thursday, and J.C. Penney and Petrobras report Friday.

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Questions? Comments? Email us at marketinsider@cnbc.com

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.