Already frightened by fears about Europe’s debt crisis and China’s latest tightening, financial markets got really spooked Monday morning when Standard & Poor’s cut its outlook on America’s AAA debt rating to negative from stable.

The idea America could lose its AAA rating is not new but S&P’s action makes it more likely as a real-world event; specifically, the outlook revision means a 33% chance of a rating change within 2 years, according to S&P.

An actual debt downgrade would raise the cost of interest payments for the U.S. government, as well as raise borrowing costs for U.S. consumers and corporations. Higher rates would have a crushing effect on the debt-laden U.S. economy, which helps explain the market’s reaction: Treasury prices fell, sending yields higher, while money flowed out of stocks and other “risk” assets.

In recent trading, the Dow was down more than 200 points to 12,134 while the S&P was trading below the key 1300 level. With the notable exception of precious metals, commodity prices were also tumbling, with notable decline in oil and copper. In addition to silver and gold, the volatility was the big winner with the S&P Volatility Index (VIX) up 18%.

In the accompanying video, I discuss S&P’s action and the market’s response with my Breakout colleague Jeff Macke and Mark Dow, a fund manager at Pharo Management, which has about $4 billion of assets.

“We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns,” S&P said in a statement announcing the change.

“They have to be careful: you can’t yell fire in a crowded theater,” Dow says of S&P. “But it’s a good time to do it with the debt ceiling coming up. There’s reason for concern — if people don’t get on the ball quickly we’re going to have problems not too far out.”

And if this kind of market action persists, the problems will be here sooner vs. later.

Source: Yahoo Finance

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