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Rajdeep Sengupta

Rajdeep Sengupta has been an economist in the Research division of the Federal Reserve Bank of St. Louis since 2006. His main expertise is financial intermediation and corporate finance. Recently, Sengupta also has studied the behavior of subprime mortgages prior to the financial crisis. He is from India and has been in the U.S. since 2001. He is an avid fan of cricket and soccer.

What impact will the downgrade of U.S. debt have on the country's ability to sell debt in the future?

On Aug. 5, Standard & Poor's downgraded the United States' credit rating for the first time in the history of credit ratings. This was a major development because, throughout recorded financial history, U.S. Treasury debt has been considered the safest debt instrument available. The reason for the downgrade was given as "the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate." Taken at face value, this implies increased uncertainty of timely payment of interest and principal on U.S. Treasury obligations.

Typically, the downgrade of sovereign credit ratings is accompanied by a flight of capital away from the country and, in some cases, a sharp depreciation of the sovereign currency. Surprisingly, however, what occurred following the U.S. downgrade was the exact opposite: a sharp decline in both equity and commodity markets and a flight toward U.S. Treasury securities—the subject of the downgrade. Consequently, the yields on the benchmark 10-year Treasury notes fell to their lowest levels since January 2009.

This anomalous behavior can have several explanations. First, despite the downgrade, the financial markets continue to believe in the creditworthiness of the U.S. Treasury. Second, the downgrade occurred during a period of increased uncertainty about the European debt crisis; consequently, U.S. Treasury securities were still a safe haven relative to the sovereign credit risk of other major economies.

Third, immediate market reactions to sovereign credit rating downgrades have often been determined by factors other than the downgrade; following the S&P downgrade of Russia's foreign-currency sovereign credit ratings in December 2008, equity markets in Moscow actually posted gains, buoyed by soaring commodity prices.

In the future, the borrowing costs of the U.S. will almost certainly depend on its ability to resolve some of its long-term fiscal challenges. If uncertainty over U.S. debt repayment continues, global investors will seek a safer alternative to U.S. Treasuries—an alternative that has yet to emerge.

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