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Standard and Poor’s has downgraded the US sovereign rating to AA+, and kept the rating outlook at negative, suggesting improvement in the fiscal situation will be needed to avoid further downgrades. Federal agencies have issued guidance clarifying that this action will not affect risk weightings for US Treasury or agency debt.

Key Points:

1. At the conclusion of a tumultuous week in world financial markets, the rating agency Standard and Poor’s has downgraded the United States long-term sovereign credit rating from AAA for the first time in its history. The new rating is AA+ and the outlook remains negative, implying the potential for further downgrades if there is no improvement in the fiscal outlook.

2. In describing an "upside scenario" of greater than expected fiscal consolidation, S&P indicates the result would be AA+ with stable outlook. The upshot is that they appear to see little chance of restoring the previous AAA rating in the near term even if greater deficit reduction occurs. An additional one notch downgrade to AA could result from S&P’s “downside scenario” involving “less favorable” macro assumptions (2.5% real/4% nominal growth) and a failure to enact the $1.2trn in spending cuts called for in the Budget Control Act (BCA) enacted earlier this week. The BCA imposes a Nov. 23, 2011 deadline on a special congressional committee to agree on the additional savings, and Dec. 23, 2011 for Congress to pass them. Therefore, ratings uncertainty will continue.

3. The US short term rating is affirmed and still the highest possible (A1+), implying no effect on money market funds.

4. S&P has shed a bit more light on the metrics used to arrive at this decision, indicating that they have adopted the Congressional Budget Office’s alternate scenario as their baseline. The differentiating factor between AAA and AA+ appears to be not the level of debt at mid-decade, but rather the trajectory of the debt-to-GDP ratio, which S&P expects to decline by 2015 in "relevant peers" with AAA ratings. This actually implies it might be slightly easier for the US to recover the AAA rating than if the threshold were an absolute level. The political debate seems to have played a large part in the decision to downgrade, and is referenced frequently in S&P’s press release, e.g. “the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges".

5. US federal agencies have just issued guidance clarifying that S&P’s action will not affect risk weightings for US Treasury or agency debt, or the treatment of this debt under other federal banking agency regulations.