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In search of a debt-downgrade silver lining

There has been considerable fretting over the past couple of weeks about the consequences of a U.S. downgrade by the major credit-rating agencies - something that may still happen regardless of the outcome of Washington's debt-ceiling impasse. The only consensus emerging from the vacillating, uneven markets is one of uncertainty: No one really knows what to expect.

Well, that's not quite true. Another of the world's leading government bond issuers, Japan, saw its sovereign debt downgraded in 1998. And its precedent suggests that maybe - just maybe - the United States could weather a downgrade with little damage.

Japan's experience

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Barry Knapp, head of U.S. portfolio strategy at Barclays Capital in New York, noted in a report this week that in general, Japanese assets did not tumble as a result of the rating downgrade in November, 1998.

While Japanese bond prices did fall in the wake of the downgrade, pushing bond yields sharply higher, he noted that the move coincided with a sharp upturn in Japan's industrial production that led the country out of recession by early 1999. Meanwhile, the yen and the Japanese stock market both rallied after the downgrade.

Mr. Knapp concluded from the Japanese data that "macroeconomic fundamentals were the major drivers of asset prices, rather than the ratings downgrade." He said Japanese markets were more focused on the domestic economy and the country's efforts to recapitalize its banks than on the sovereign debt ratings.

Look to the economy

Of course, Japan in 1998 was not what the U.S. is today - the overwhelmingly dominant reserve currency and go-to sovereign lender to the world. It's hard to predict whether the global markets would shrug off a U.S. downgrade as easily as they did Japan's.

The Japanese downgrade came at a time of considerably stronger global economic growth than we have now, and it didn't face the current quagmire of developed-world sovereign debt issues. On the other hand, the Japanese downgrade did come during a banking crisis - the Long Term Capital Management (LTCM) collapse. "The resultant disorderly swings in capital markets make using the Japanese downgrade as a guide to potential market reactions to a possible downgrade of the U.S. sovereign debt rating rather precarious," Mr. Knapp said.

Still, he believes that macroeconomic factors were the overriding market drivers in Japan - and that would be the case in a U.S. downgrade, too. "We expect that after a brief muted market reaction, the direction of the markets will be highly leveraged to the [economic]data, with expectations of a [2011 second-half]rebound in economic activity hanging in the balance."

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