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The markets took a backwards step yesterday as the ratings agency Standard and Poors downgraded the outlook for the US economy to negative for the first time in its existence. It has been the worst kept secret in financial markets that the two main political parties in the US are ways from resolving the budgetary issues however while the UK and some European nations have embarked on a program of austerity it is only recently that the powers that be in Washington have begun to take action against the deterioration in the nation’s finances.

S&P have come out and said that this is not enough and further reforms are needed. This means that there is a 1/3rd chance that the US will lose its AAA rating in the next 2 years, a prospect that could see a huge swing away from US assets and the dollar itself. The real nightmare scenario is that where we to see a downgrade then pension funds and investment trusts that are bound by covenants to invest in only AAA rated debt would have to sell their US holdings causing a run on assets and the dollar.

We don’t foresee this happening because, as we said, this is the worst kept secret out there. This announcement by S&P should be viewed as a ‘shot across the bows’ and not a full-throated attack on the US economy. What it does do is throw into sharp contrast the problems the Europeans have with their current debt issues and the market acknowledged that by pushing the yield on Greek 10 year debt past 20% and Portugal’s past 10% for the first time in Euro-area history. That is probably the main reason that we have seen the euro and European equity markets really get daggered this afternoon.

So equity markets fell and the dollar actually gained 1.4% and 1.2% against the euro and dollar respectively. That may seem paradoxical but from a safe haven point of view the best place to be is the short end (near dated) bills put out by the Federal Reserve. Other havens such as the CHF and JPY also moved higher whilst gold closed at a new record of $1496.60 an ounce

With the general risk off atmosphere continuing today it is possible that the pound continues its recent move higher against the euro although there is significant event risk tomorrow. Both the Bank of England minutes on Wednesday and Thursday’s retail sales pose  a risk to the downside as recent data has shown that the UK economy is not moving at the pace that some had thought.

 Latest exchange rates at time of writing