Thursday, January 27, 2011

Japan's Credit Downgraded, U.S. Next In Line

TV character Gomer Pyle used to say "Surprise, surprise, surprise!" whenever something obvious caught everyone else off guard.  Some things are so obvious that no one should be surprised when they happen.  Credit downgrades for the world's largest and supposedly healthiest economies have been discussed as potential events that were far removed from the here and now.  Such a downgrade is no longer theoretical.  It is now a reality for Japan:

Japan’s credit rating was cut for the first time in nine years by Standard & Poor’s as persistent deflation and political gridlock undermine efforts to reduce a 943 trillion yen ($11 trillion) debt burden.

Downgrades will also soon be reality for the U.S.  The Congressional Budget Office forecasts that the U.S. federal budget deficit will approach $1.5T in 2011.  The deficit cannot grow indefinitely.  A credit downgrade will force Treasury yields up and make borrowing harder.  When the Fed's endless QE packages start to turn off foreign bond investors, corporate debt issuers will have to raise the coupons on their new debt issues to keep investors interested.  We saw this start to occur during the 2008 credit crisis and it ultimately led to private credit markets going into cardiac arrest as available credit dried up.  That panic required a massive government backstop in September 2008 that can no longer be replicated without the Fed expanding its balance sheet to infinity.  Even a hint of approaching that event horizon will launch a global run on the U.S. dollar and hyperinflation in America. 

Note that Japan is much farther along the path to credit deterioration than the U.S. and the yen is not the world's reserve currency.  The U.S.'s window of opportunity to cut its deficit and avoid a sovereign credit downgrade is open for an unknown duration.  It will slam shut when non-U.S. bond buyers or corporate credit issuers throw in the towel on the dollar.  When that window slams, a lot of people will find their financial fingers are broken.  Don't be surprised.