Credit Downgrade May Trigger Inflation, Slow Home Sales

By Mike Colpitts

As the U.S. economy sputters in over-drive to recover from the worst economic crisis since at least the Great Depression, Standard and wall street bull Poor’s downgrade of the economy is likely to re-set mortgage interest rates on millions of adjustable rate mortgages, send the costs of doing business higher and slow home sales, weakening the chances of a recovery in the housing market. The downgrade is also likely to trigger inflation.

The unprecedented move Friday by S&P sets in motion a nightmare scenario of epic economic forces that is likely to trigger inflationary pressures to develop. But the course or real impact of the scenario is difficult, if not impossible for economists and real estate analysts to pin-point considering the U.S. has never lost its highly coveted triple A rating before in the nation’s history.

However, a 1-percent rise in mortgage rates would send a $200,000 mortgage at 4% up by $118.81 a month and $1,425.72 a year. Over the life-span of a 30-year fixed rate mortgage at the higher 5% rate it would be an increase of $42,772.49 not including taxes and insurance.

An increase in interest rates would also slow home sales. Businesses would pay more to borrow money to stay in business to pay employees, buy inventory of products and goods to sell and to pay bills on utilities and other expenses.

The downgrade is being criticized by politicians in Congress, who blame each others’ party for failing to reach a full agreement in time to leave Washington, D.C. for the month of August on vacation, only agreeing to extend the nation’s spending limit, and appoint a panel to come up with other cuts later in the year.

Effectively raising the costs for borrowers could drive inflation to increase the costs of goods and services, including utilities, groceries and the costs of other necessities. The interest the U.S. government pays to finance the nation’s growing debt is expected to rise as countries financing it demand more to continue to finance the U.S. deficit.

credit agencies

China is the biggest holder of U.S. Treasuries followed by a handful of other countries, including Brazil and private individuals. However, with the yield paid to investors on Treasury bonds declining over the past week, it seems more likely that fewer investors will find Treasuries as an attractive investment.

U.S. Treasury bonds have historically been viewed by investors as a safe haven where they could invest their money because of their historically high ratings. The downgrade could also result in greater job losses as a result of a drop in Gross National Production (GNP) and business lay-offs as companies hold tight to their cash reserves.

The boomerang effect is also likely to take the U.S. housing market into slower territory. Slower home sales this summer have already troubled the marketplace, despite near record low mortgage interest rates. A soft housing market for a longer period would translate to even lower home prices as more homeowners give up on recouping home values and walk way from their homes or are forced to do so.

Financial experts also forecast that the stock market will sell-off 6 to 10% as a result of the downgrade. But the forecasts are mostly mere estimates by seasoned Wall Street veterans hoping that the fall-out won’t be much worse.

The downgrade could also push Congress to take greater actions in a more timely fashion. “The American people realize that our nation can no longer afford to stay on this same path of reckless spending and follow the status quo of Washington,” said Congressman Ron Paul (R-Texas) who is running for U.S. President.

“If Washington refuses to take heed, there is little cause for optimism. Growing inflation, rising gasoline and food prices, and trillion-dollar budget deficits will all soon seem like minor issues if our nation does not immediately change our monetary and spending policies.”