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Wall Street to investors: Don’t panic

August 7, 2011, 5:29 PM UTC

Wall Street is jumping to the defense of the United States government following Standard & Poor’s decision Friday night to downgrade its sovereign debt. The financial community is circling the wagons in an attempt to avoid a major panic when the markets reopen Monday, holding conference calls with nervous investors and downplaying the importance of credit-rating agencies in the financial markets.

But the credit downgrade should not be taken lightly. Such an event is unprecedented and could end up having wide-reaching economic and political implications. While much of the shock of the downgrade should have subsided by Monday’s opening, there is still a chance that the emotions of investors could overtake even the loudest shills from The Street, setting the markets up for a sharp fall.

S&P’s decision couldn’t have come at a worse time for the markets. The S&P 500 (SPX) fell 7.4% last week, its worst performance since the dark days of November 2008 when the credit crisis went into overdrive. Panic selling was behind much of the 2008 correction and it may have also had a role in last week’s market dive as concerned investors liquidated their portfolios, converting them into cash or other supposedly “risk-free” instruments, including Treasuries.

S&P’s decision to downgrade U.S. debt from its implied risk-free credit rating of AAA to AA+ has put in doubt one of the last investment vehicles considered to be a safe haven. The urge to pull more money out of the market and hide it under a mattress could therefore intensify, creating a downward spiral in prices across all asset classes.

Managing expectations

But many Wall Street economists and money managers are downplaying S&P’s move, saying that the downgrade wasn’t a big surprise. After all, S&P did say in July that it would probably downgrade the U.S. if the government failed to produce a plan to reduce the Federal deficit by $4 trillion over the next ten years. When Congress finally produced a plan at the 11th hour to raise the debt ceiling, it proposed just $2.1 trillion in cuts.

What was a surprise to some economists was the timing of the announcement, coming on the heels of a market rout and before the bi-partisan debt “super committee” meets in Washington to discuss decide on what should be cut from the budget. But S&P said that it questioned the U.S. political will to make the tough cuts needed to get close to the $4 trillion mark.

Now Wall Street is pushing the idea that investors have already priced in a potential downgrade. This means markets probably won’t go into freefall on Monday – they could even possibly strengthen given the sunny job numbers that came out at the end of last week.

But even if investors saw this coming it doesn’t mean they were prepared. One of the largest fears surrounding a downgrade is that certain large funds would be forced to sell U.S. debt on a downgrade as their investment mandates require them to hold a certain percentage of their assets in triple-A rated securities. This forced selling would then be the catalyst that could set off a major panic, sending the markets into a tailspin.

This continues to be a controversial topic, but Wall Street is claiming that such draconian mandates are rare and that most firms have enough wiggle room to allow them to hold U.S. debt, even if it no longer carries the top rating from the credit rating agencies. Analysts at JP Morgan (JPM) believe that the potential for forced selling seems low and estimates that at the worst, the market could see around $40 billion in forced selling. That’s not exactly pocket change, but it is just 0.4% of the $10 trillion of tradable U.S. government bonds available. Furthermore, it is unclear when firms must cash out of their Treasuries as mandates may call for liquidation over time as opposed to all at once.

The sheer size of the U.S. debt market is one reason why people turn to it as a safe haven. Its largess is a reflection of the U.S. dollar being the world’s reserve currency. That means simply that most foreign central banks are required to hold dollars and Treasuries to back up their own domestic currency and to balance their trade flows with the U.S. Around 40% of Treasuries are held by foreign governments and there seems to be no indication that they will be dumping them come Monday. Officials from China, Japan and the UK, the top holders of U.S. debt, have already sent signals over the weekend that they do not plan on dumping it.

But some traders are quick to point out that last week, when there was some panic selling in the stock market in the wake of the European sovereign debt crisis, investors chose to buy Treasuries, knowing full well that a downgrade was likely. Yields on the 10-year government bond fell to as low as to 2.56% last week.

Sell-off is a buying opportunity

Adding up what the effect a downgrade would have on bond yields is a bit tricky. If demand for 10-year bonds holds steady, then rates should hold as the government would need to offer a higher yields to attract customers. Economists on Wall Street have indicated that a 25 to 60 basis-point increase in yield may occur on the 10-year Treasury bond – pushing rates up to around 3%. That’s still relatively low compared to the yields now being seen in Europe, where, for example, Italian 10-year bonds just hit 6% last week.

Despite the uncertainty, some asset managers are trying to calm their clients by putting a positive spin on the downgrade. Any major dislocation in the market creates a buying opportunity for those with the dry powder.

“We don’t know exactly how markets will open on Monday morning – we will get some indication Sunday night – but often times we really look at these situations as opportunities, because macro events like this tend to impact markets very broadly and not very specifically,” Ed Perks, a portfolio manager at Franklin Templeton Investments, who oversees over $30 billion in assets, tells Fortune. “Our investment process tries to leverage fundamental research and we will try to identify opportunities on that Monday or Tuesday.”

The sheer volatility in the market as a result of the downgrade could end up helping, not hurting some investors, especially hedge funds, which thrive on market volatility. Instead of a panic there could possibly be a rally as investors flood the market with orders.

While that may be good for Wall Street in the short term, the long term negative effects of a downgrade could come back to haunt it and the rest of the U.S. economy. An increasing number of foreign governments are slowly diversifying their reserves away from the dollar, a process that could accelerate in the coming weeks due to the downgrade. For example, South Korea last week passed on the U.S. dollar and bought gold for the first time in 13 years to fill its reserves. If strong allies like South Korea continue to shift away from the dollar, it will be a drag on the U.S. economic growth rate, as domestic savings would have to rise to fill in the gap.

Wall Street believes that its cool response and analytical reasoning will help alleviate any major panic on Monday. But panic is at its core irrational. Trying to counter panic with logic can be a futile exercise. What we are seeing is a loss of confidence in market systems around the world – from the European Central Bank to the Federal Reserve. The monetary systems of both the U.S. and Europe require confidence on the part of investors to operate given that the money is largely backed by faith, not gold. If investors no longer believe that system is viable, a one notch downgrade by a credit rating agency will look like a footnote in the coming economic calamity.