August 9, 2011 - The Second Shoe Falls in the Downgrade Crisis

1) The Second Shoe Falls in the Downgrade Crisis. Today, Standard and Poor's fired the second barrel of its shotgun at the credit worthiness of the US with its downgrade of Fannie Mae debt from triple 'A' to AA+. Other government-backed securities are soon expected to suffer a similar fate.

The move snuffed out a nascent rally in stocks, sending them into a new tailspin, with the (SPX) ticking as low as 1,110. Gold renewed its high, tacking on a breathtaking $60 from the Friday lows. Copper really took it on the chin, trading as low as $3.91. Even corn was seeing some serious selling, dropping 10% in a handful of sessions. These are moves you will tell your grandchildren about. These days, you don't sell what you want to, you sell what you can.

As of today, the market has given up all of the positive impact QE2 had on stock prices since it was launched last November. The S&P 500 is now down 12.8% year to date and up only 2.7% YOY.

There had been hope in the overnight session that buying of Italian and Spanish bonds by the European Central Bank, which caused yields there to crash more than 100 basis points, would put a floor under market. Standard and Poor's thought otherwise. The disgraced rating agency is now hinting that it may purse a second downgrade of Treasury bonds as early as November.

Reading the downgrade report over the weekend, it's clear why Standard and Poor's acted when it did. The refusal of the House Republicans to raise taxes under any circumstances was a major consideration in its decision. Standard and Poor's has pored over the figures for federal income and expenditure. as I have and have, and reached the same conclusion: that any balancing of the budget without tax hikes is a mathematical impossibility. This condition may continue until well after the next election and beyond.

The agency is also deeply concerned about the willingness of many members of congress to push the US into default for political reasons, even though it has the resources to avoid it. Political risk is now being ascribed to US government securities for the first time ever.

Don't overweight the importance of Standard and Poor's move. At the end of the day, this is just one private research boutique's opinion. The other two ratings agencies have disagreed. I get a ton a research sent to me every day by similar organizations, and most of it is garbage. Is America's credit worthiness really just one notch above Slovenia's?

I was a regular follower of the sovereign debt default scene during the seventies and eighties, when Argentina, Brazil, and sub Saharan Africa were regular miscreants. The International Monetary Fund would read them the riot act, withholding bail out money until it obtained commitments on huge spending cuts and tax increases from the offending government. Painful declines in the standard of living always followed.

It is somewhat humorous to see Standard and Poor's force feed the same medicine to the US. It's proof that if you live long enough, you see everything.

Please don't confuse Monday's cataclysmic market action, down 604 Dow points at its worst, with the downgrade or the debt ceiling compromise. These are distractions. The real driver here is fear about the long term future of the US economy, and those fears are valid.

I don't believe we are imminently going into recession, and I expect the risk markets to have a rapid bounce back almost as ferocious as the decline. Watch for gold and the VIX to top soon to prove that I'm right.

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