'Severe' at First But No Debt Armageddon: Economist

The Standard & Poor's downgrade of America's long-term credit rating will surely rock markets when they open on Sunday night, but any spike in US Treasury yields will be short-lived, according to Paul Dales, the chief economist at Capital Economics.

U.S. Department of Treasury headquarters in Washington, D.C.
Source: wikipedia

"The initial reaction when the financial markets open on Monday could be severe, especially coming after the turmoil of this week. But we are not convinced that the downgrade will bring on Armageddon," Dales said in a research note.

Noting that Canada and Australia once lost AAA ratings, Dales notes even S&P believe the US has "an extremely strong" capacity to meet its financial obligations.

"Very few investors are constrained to holding only AAA paper. A statement by the Federal Reserve late Friday night confirmed that US government debt would still be high grade and 0% risk weighted for banks under the Basel II rules" said Dales.

"Fears of disruptions to money market funds should not materialize either, as they primarily invest in short-term securities, which have their own rating," said Dales, who also noted that both Moody's and Fitch rate US debt at the highest level possible.

That does not mean the downgrade will not cause problems for the US economy, he said.

"The downgrade comes at a time when the financial markets and advanced economies are already very fragile. The extra uncertainty could easily prolong the latest slide in equity prices. In the very worse case scenario, this could prove to be the trigger for another financial crisis that sends the US and other Western economies back into recession," said Dales, who believes any selling when the market opens will be temporary.

"It won't be long before the markets focus once again on the economic fundamentals. As those are not great, the S&P 500 will do no better than to stay close to its current level of 1,200 and Treasury yields will remain around 2.5 percent."

"The loss of America's AAA rating is the clearest sign yet that the fall-out from the global financial crisis will be felt for many years to come," Dales said.