By Vitaly Katsenelson CFA, author of The Little Book of Sideways Markets and Active Value Investing. Vitaliy’s website is Contrarian Edge

I have received many emails and a few calls from friends, asking one question: What are the consequences of the downgrade? So I decided to put my thoughts on paper.  I break up the consequences into three categories: fundamental (the impact on the economy), emotional (the short-term impact on the market), and political (will it change anything in Washington DC?).

Fundamental: AA+ is the new AAA.

The Fed and the FDIC set bank reserve requirements; they decide what is quality and what is not on banks’ balance sheets.  To little surprise, a few hours after the downgrade, the Fed and FDIC announced that AA+ US debt is as good as AAA, and thus banks’ reserve requirements will not change and bank lending should not change either.  Though we’ll probably get a few downgrades of financial companies holding US treasuries, the direct impact on financial institutions should be negligible.

The indirect impact of the downgrade is worrisome, however, because unknowns are simply … unknown.  The AAA government debt rating is a foundation stone of the world financial system, and when it shifts, even a little, other things may shift as well.  Unintended consequences may be surprising. For instance, until Lehman collapsed it was hard to imagine that the Reserve Fund (the first US money market fund) would see its price decline a few pennies bellow the dollar, causing a massive exodus out of money market funds and a resultant freezing of the commercial paper market – the lifeblood of corporate America.  The federal government had to step in and guarantee all money markets to stop the bleeding.

Scandinavian countries and Switzerland are probably the only true AAA nations left, but their economies are not big enough for them to field reserve currencies, and in fact Switzerland is trying to devalue its currency, as its exporters are hurting from the highly appreciated Swiss franc.

The US’s cost of borrowing is unlikely to increase, not yet, not while PIIGS (Portugal, Italy, Ireland, Greece, and Spain) are rampaging through Europe.  The US still has the largest, most robust, most diversified economy, and despite our problems we are in better shape than Western Europe, which is chained to a common currency and whose banks are overleveraged through their exposure to PIIGS.

The only downgrade that will really matter to our cost of borrowing in the long run is the one imposed by the bond markets.  Credit agency ratings are important in the short run, because their ratings are deeply embedded in the financial system by regulators (and governments), but in the longer run it is the markets’ own ratings that will matter.  Markets will perform their own credit analysis of countries and will do their own debt downgrading, i.e., they’ll demand higher interest rates.  Japanese debt was downgraded to AA- in January 2011.  It was a nonevent.  Despite being the most indebted developed nation, Japan is still borrowing at the same pre-downgrade rates, which are half of the rates the US government pays on its debt.  On the other hand, Italy’s 10-year bond rates jumped to 6% in August without any downgrade by credit agencies: the markets did their own credit analysis.

The chance the US will default on its debt in a traditional sense is zero. Yes, zero.  All of our obligations are in US dollars. Governments that can print their own currencies don’t go through traditional default, they default through the printing press (i.e., by inflation).  It will take a few more dollars to buy bread, vodka, potatoes, and cigarettes (I am going authentic here) year after year.  The US government will honor its obligations in nominal terms (ignoring inflation), meanwhile defaulting on its debt in real terms (adjusted for inflation).

Emotional Consequences

I was going to write a note on this topic before the S&P downgrade, so I’ll expand it a bit further.  I was on a radio show on Friday, and I was asked why the markets declined 7% this week.  I said, “Markets were ignoring bad news for a while and now decided to stop ignoring it.”  I sounded smart; I even patted myself on the back.

But a few hours later I was driving home and started thinking what baloney that was.  The market declined because it declined.  There is no need for an explanation, because there really is not one.  We don’t need an explanation why the market goes up, we consider it our birthright.  But a market decline seems somewhat unnatural to us.  Financial TV explains to us in great detail the market’s tick by tick movements. For example, on Friday the jobs report came out – the US economy added 117,000 jobs.  The Dow went up 150 points or so right away, as financial TV explained that the market was expecting a worse number, so this was a good surprise.  Then, two hours later, the market declined 250 points (that is, down 400 points from the opening high); and the explanation we heard was that the job number was not really that good, after all, because we needed 150,000 jobs or so just to maintain our current same employment level, because of population growth, so in reality employment had declined by 33,000 jobs.

I understand why financial TV does this.  You are not going to stay tuned to financial TV all day long if all you hear is that the market went up 150 points because it did, and then declined 250 points because it does that from time to time.  This would be some boring TV.

In reality, market movements – including intraday, daily, and monthly movements – are largely random and not predictable.  Explaining what they do tick by tick on a continuous basis has as much value as trying to come up with a rational explanation why the ball landed on the 9 on the roulette table in Bellagio instead of 10.

This brings me to the question of how markets will react to the downgrade.  I have no idea.  If they were to decline, I would not mind, as we have a little bit less than 30% cash, and I want to put it to work (we bought a few stocks last week).  Also, a bulk of the companies in our portfolio are actively buying back a meaningful amount of their stock in the open market, and I want them to buy their stock cheaper, as it will raise their earnings power.  But if you are an investor you need to have a time horizon longer than a week or a month.

Political Consequences

Hallelujah!  Last week I wrote about the Pyrrhic victory of the debt-ceiling debate:

A Pyrrhic victory is so-called after the Greek king Pyrrhus, who, after suffering heavy losses in defeating the Romans in 279 B.C., said to those sent to congratulate him, “Another such victory over the Romans and we are undone.”   Dictionary.com

A quick thought on the debt-ceiling debacle.  I believe that by August 2nd we’ll see the debt ceiling increased, as the cost of not doing so is simply unknown and most likely too high.  However, it will be a Pyrrhic victory for whatever side claims it,

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