The sell-off really kicked in two weeks ago, when it became clear that even with a short-term debt ceiling hike, we were likely to be downgraded. Last night, S&P cut the U.S. rating to AA+ from AAA. This leaves only Germany and the UK as AAA among the largest economies, with Japan at AA- and China at AA-. I would expect that Germany and the UK will be cut by S&P as well.
Who knows if the market will react strongly or not. It is certainly something that could trigger a knee-jerk reaction, but it's not likely to mean a lot and was certainly expected to a great degree. The politicians were way wrong about substantially higher borrowing costs in my view. There could be some dislocations, as many investors require AAA. It remains to be seen how things play out, but guidelines can be changed and holdings don't need to be sold necessarily, though it could impact new investments.
The real story is that governments around the world are struggling post-crisis. Europe is in a lot worse shape than the U.S. Corporate balance sheets generally are strong, the banking system has improved itself over the past few years, Consumers remain pinched and Government debt is a problem. In the long run, when global economic growth normalizes, the issue becomes less challenging.
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