By now you've likely heard the news. The childish behavior of our nation's political "leadership" has led to the first ever downgrade of the U.S. credit rating.

(Reuters) - The United States lost its top-tier AAA credit rating from Standard & Poor's on Friday in an unprecedented blow to the world's largest economy in the wake of a political battle that took the country to the brink of default.

"The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics," S&P said in a statement.

This is what hit the wire on Friday night....

RTRS - 05-Aug-2011 20:15 - S&P DOWNGRADES UNITED STATES' CREDIT RATING TO AA-PLUS WITH NEGATIVE OUTLOOK

RTRS - 05-Aug-2011 20:17 - S&P SAYS DOWNGRADE REFLECTS OPINION THAT US FISCAL CONSOLIDATION PLAN FALLS SHORT OF WHAT WOULD BE NECESSARY TO STABILIZE DEBT DYNAMICS

RTRS - 05-Aug-2011 20:18 - S&P SAYS EFFECTIVENESS, STABILITY, AND PREDICTABILITY OF US POLICYMAKING AND POLITICAL INSTITUTIONS HAVE WEAKENED

RTRS - 05-Aug-2011 20:19 - S&P SAYS PESSIMISTIC ABOUT CAPACITY OF CONGRESS AND ADMINISTRATION TO REACH BROADER FISCAL CONSOLIDATION PLAN

RTRS - 05-Aug-2011 20:21 - S&P SAYS CAN LOWER US RATINGS AGAIN IN NEXT 2 YEARS IF SEES LESS SPENDING REDUCTION THAN AGREED, HIGHER INTEREST RATES, NEW FISCAL PRESSURES

RTRS - 05-Aug-2011 20:25 - S&P SAYS US POLITICAL BRINKSMANSHIP SHOWS US GOVERNANCE AND POLICYMAKING BECAME LESS STABLE, LESS EFFECTIVE, LESS PREDICTABLE

RTRS - 05-Aug-2011 20:26 - S&P CITES USE OF DEBT CEILING, THREAT OF DEFAULT AS POLITICAL BARGAINING CHIPS IN FISCAL POLICY DEBATE

RTRS - 05-Aug-2011 20:28 - S&P SAYS ELECTED OFFICIALS REMAIN WARY OF TACKLING THE STRUCTURAL ISSUES REQUIRED TO ADDRESS RISING US PUBLIC DEBT

RTRS - 05-Aug-2011 20:31 - S&P SAYS AFTER 2012 ELECTIONS DEBT BURDEN WILL BE HIGHER, NEEDED FISCAL ADJUSTMENT POTENTIALLY GREATER

RTRS - 05-Aug-2011 20:33 - S&P PROJECTS US NET GENERAL GOVERNMENT DEBT TO GROW TO 79 PCT IN 2015, 85 PCT BY 2021 DESPITE $2.1 TRILLION SPENDING CUTS

RTRS - 05-Aug-2011 20:34 - S&P ASSUMES THAT BUSH TAX CUTS WILL REMAIN IN PLACE BECAUSE OF RESISTANCE FROM REPUBLICANS

First and foremost, there is no reason to panic. U.S. credit was downgraded by one ratings agency, we still have a AAA status at Moody's and Fitch. The Federal Reserve will still take TSYs as collateral at the discount window...

Agencies Issue Guidance on Federal Debt

Earlier today, Standard & Poor's rating agency lowered the long-term rating of the U.S. government and federal agencies from AAA to AA+. With regard to this action, the federal banking agencies are providing the following guidance to banks, savings associations, credit unions, and bank and savings and loan holding companies (collectively, banking organizations).

For risk-based capital purposes, the risk weights for Treasury securities and other securities issued or guaranteed by the U.S. government, government agencies, and government-sponsored entities will not change. The treatment of Treasury securities and other securities issued or guaranteed by the U.S. government, government agencies, and government-sponsored entities under other federal banking agency regulations, including, for example, the Federal Reserve Board's Regulation W, will also be unaffected. Collateral Guidelines

That message goes out to all the money managers and global central bankers who are pondering a strategic shift in their cash reserves. Don't freak out! Yes I would be nervous and paying very close attention to how the U.S. market reacts in the morning as well as the continuing communication from Fitch and Moody's, but now is not the time to panic. Just stay nimble and see how everyone else reacts.  

How might markets react?

Downgrade rumors were leaked on Friday morning and there was plenty chatter on the street about it; we alerted our readers before 11am. At the time we witnessed broad-based selling of dollar denominated assets,  which tells us the market may have already taken it upon itself to discount asset-values in advance (not discounting the timing or certainty of cash-flows though). From that perspective we could've already seen the largest unfriendly price swings in longer-dated TSYs.

That's a rosy outlook though and I'm not willing to take an optimistic stance here, it's too early. This is clearly one of those "wait and see how everyone else reacts" environments. The entire investing world is nervous and wondering what to expect. I think we all feel that way. Right?  There are multiple scenarios that could play out with various reactionary paths to follow. Before we get all worked up, perhaps now is the right time to  remind folks that we should be used to this already. You know, the excessive amount of uncertainty that's greatly distorted our point of view over the last two years? Assumptions have been based on assumptions of assumptions. We're all suffering from the effects of headline exhaustion. What's a little more uncertainty mean at this point?

There are tactical motivations to consider though... several that lead me to believe rates are more inclined to tick higher in the days ahead. We need to look past the ratings downgrade.

We have a 3-year note auction, 10-year note auction and 30-year bond auction on Tuesday, Wednesday and Thursday respectively.  Traders always look for a chance to force a price concession out of TSY when the government needs to raise money, regardless of a ratings downgrade; especially after such aggressive curve flattening (remember the massive rally mortgage rates have enjoyed over the past 6 sessions?)

Another consideration is the extent to which the market has already accounted for economic weakness in benchmark rates. We know short covering played a role in the TSY rally and stocks have been "bid wanted" lately (a factor of rallying in TSYs?), so we have to consider the notion that the market may have gotten too far ahead of weak econ fundamentals. Positive revisions to previous jobs months data and a stronger than expected July employment report  (which included wage growth) backs up that assumption. We need more confirmation of weak econ fundamentals....

And then we throw a Fed meeting into the mix. Given the generally poor fundamental outlook (2Q GDP, weak consumer confidence, contracting global manufacturing sector), it's safe to think investors are expecting a modest downgrade from the Fed this week... but that may not be the case. The Fed has largely described this slowdown as "transitory", a function of fallout from the Japanese earthquake and the impact of rising costs of living. From that perspective, the upcoming FOMC statement may acknowledge continued barriers to growth but will likely stick to the "wait and see"/ better 2nd half of the year outlook.So we'd prefer to reserve Jackson Hole for any notable shifts in outlook from Benny B. Not an FOMC just after the U.S. credit rating was cut. A lack of bearish rhetoric from the Fed would be bad for TSYs in the short-term, especially with dealers already looking to trade 'em from the short side ahead of auction supply.

But TSY refinances U.S. debt almost daily. If market the forces TSY to pay up on fundraisers this week, will it continue to do so in every auction? Not likely. There isn't much of a choice for global investors here. Shunning the U.S. now would only hurt their own cause. "Cutting off nose to spite face".

Our biggest debt holders and most of the world don't really have another scalable "flight to safety" option in the immediate timeline; here we find support from global central bankers who must defend our debt to defend their own.  The market knows this and it also knows the U.S. will pay its bills. But will the market push the government's borrowing costs higher just because it can? That depends on what other options investors have for "flight to safety" assets. Maybe the forex market? Swiss franc has seen huge FTQ bid. Of course hard assets like gold and silver are likely to benefit.   I suppose German bunds are another option but can we really say that any EU backed bond is better than a U.S. TSY?  SEE ECONOMIST STORY RE: TURNING JAPANESE

What about equities? Can any case be made to buy stocks right now? The only one I can think of is "bargain buying", but that depends on your appetite for risk, and I'm not feeling hungry.  I just want to live to fight another day...

Overall I think rates will rise on this downgrade, but only temporarily.  I see a range trade between 2.52 and 2.85 in 10s until Jackson Hole. Yes that means the direction of mortgage rates remains at the mercy of the direction of benchmark TSYs and the shape of the yield curve. I'd be more willing to sell the long end but only because I know dealers are exhausted and looking to trade this from the short side ahead of 3/10s/30s auction supply.

In terms of loan pricing, there is an added degree of volatility to consider. And it's already been a long two weeks for pipeline hedgers. We've all been reminded that volatility is not a friend to secondary marketing managers or rate sheets (extra margin).  The convexity vortex that sucked 3.5s up to parity and fuzzied fallout assumptions can be blamed for that...

I look for rates to tick higher early this week but any spikes will be contained by the lack of positive progress in our economic outlook. Our recovery is being weighed down by a lost generation of labor thanks to advances in productivity and a lack of tailored skills (automation/technology = winning). And housing, well housing continues to stagnate in a pool of its own filth and politicians don't seem to care. READ MORE: Politicians Overlook Role of Housing in Economic Recovery

From that perspective, I am sticking to our current guidance....

GUIDANCE: Our long-term mortgage rate outlook finally came true last week.  And although borrowing costs rose on Friday, we still believe mortgage rates have room to rally further, especially when considering that lenders have been slow to pass along gains. Recovering those losses may take a few days or even weeks and the environment could get stressful, but our economic outlook remains supportive of a return to historic lows.  We backed-up that perspective in this post: Bond Market Officially Repeats History. Reality Restored.