Since last week, financial markets worldwide have been shaken by uncertainty. Reuters news agency estimates that US$2.5 trillion was wiped from the value of global stock markets in just eight days. The main reason for this turmoil is probably investors’ fears of a double-dip recession in the wake of the US’ and EU’s debt crises and weak economic performances. To make matters worse, on Aug. 5, Standard & Poor’s (S&P) stunned global financial markets by cutting the US’ sovereign credit rating from “AAA” to “AA+.” It is hard to foresee how much of an impact this unprecedented move might have.
The compromise plan enacted in Washington calls for US$2.4 trillion in spending cuts over the next 10 years, while raising the limit for US government borrowing from US$14.3 trillion to US$16.4 trillion. Many people thought that the impact of the debate about the US’ debt would end when the bill was passed, but that was not the case.
The first data released following the deal showed a decline in US consumer spending. This was followed by news that adjusted US GDP growth for the first quarter of this year was 0.4 percent, down sharply from an earlier estimate of 1.9 percent, and that the economy grew only 1.3 percent in the second quarter. Next, while Washington announced that the unemployment rate slid to 9.2 percent last month from 9.1 percent in June, experts blew the cover off this apparently good news by pointing out that the real reason for the fall was the number of unemployed people who had dropped out of the job market because they had given up trying to find work.
In addition, the US deficit-reduction plan includes cuts in unemployment benefits, welfare spending and other measures that have heightened people’s fear and uncertainty about the future. Under threat of a second recession, investors, feeling pessimistic and insecure, are looking for safe havens for their investments. They have been withdrawing funds in US dollars from financial markets worldwide, causing market indices to fall and the value of the US dollar to rise. However, some of these funds have been converted into Swiss francs, yen, gold and other markets, so the US dollar still ended up losing value.
S&P’s lowered credit rating for the US is having widespread repercussions. In the past, US Treasury bonds enjoyed the optimum triple-A rating, so they were generally seen as a zero-risk investment instrument and served as a benchmark for floating interest rates.
Now that the US government has had its credit rating cut, US Treasury bonds will no longer be seen as a zero-risk investment. Consequently, the entire interest rate structure associated with them needs to be rebuilt and that will be a major operation.
There are about 7,000 US government-associated debt securities, all of whose credit ratings will be affected. When credit ratings slide, interest rates will go up and the price of debt securities will fall. Bondholders stand to lose out, so they may have to adjust their investment portfolios accordingly. In the short term, this is likely to cause volatility throughout the market. If the result is a fall in demand for US bonds, the US Federal Reserve will once again be forced to print money and the after-effects of that would be even harder to fix.
In Europe, problems have surfaced one after another, starting with the Greek debt crisis, which has spread to Italy, Spain and other countries in the eurozone. The economies of most of these debtor nations are not strong enough to make good on their repayment pledges and the EU has not managed to find a radical policy solution. Short-term painkillers have limited effect, so investors are treading carefully. At the same time, European banks hold too many dubious European debt securities, and their excessive risk exposure may lead to a financial crisis.