Video – Q&A Session, featuring Ron C. Dugan, CFA, vice president and global investment strategist at GuideStone Capital Management.
What happened?
Standard & Poor’s (S&P) downgraded the long-term rating for US Treasury debt one level from AAA to AA+ after the market closed on Friday, August 5, 2011.
What about the other rating agencies?
S&P was the only rating agency to take this action. Fitch Ratings and Moody’s Investors Services affirmed their AAA rating for US Treasury debt on August 2, 2011, after Washington approved an immediate increase in the U.S. Debt Ceiling by $2.1 trillion and U.S. government spending cuts amounting to as much as $2.4 trillion over the next ten years.
Why did this happen?
In the report, S&P stated, “the downgrade reflects their view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than they envisioned when a negative outlook was assigned to the rating on April 18, 2011.”
What does that mean?
In S&P’s opinion, the agreement on August 2 to cut up to $2.4 trillion in government spending was not enough to show substantial progress towards developing a credible, long-term plan to address debt reduction.
You mentioned ‘long-term rating’. Is there a short-term rating?
S&P maintains two ratings, long-term and short-term. While the long-term rating was reduced by one level, S&P affirmed the short-term rating of A-1+ which is the rating for all U.S. Treasury Bills, and the highest rating available.
Why is this event such a big deal?
Clearly, the U.S. is not your average sovereign credit. While other sovereign credits have been downgraded in the past, a downgrade of the U.S. is unprecedented and thus it is difficult to predict the markets’ reaction. In spite of this issue, there is a strong demand for U.S. Treasury securities by investors given the current economic environment and market volatility as evidenced by the recent pricing strength in these investments.
What are some of the possible effects as a result of this downgrade?
1. A downgrade would imply higher interest rates if other things are equal. Several factors contribute to a country’s level of interest rates, including monetary policy, inflation expectations and growth expectations, but creditworthiness is certainly a large factor contributing to the interest rate a country must pay to issue debt. A downgrade could lead to higher borrowing costs for the U.S. government, and thus its debt service would become a larger portion of the U.S. budget.
a. This could also lead to the downgrade of many related entities that are dependent upon the federal government for support as their ratings are linked to the rating of the federal government. This would include the FDIC-guaranteed debt issued by financial institutions, the debt of other government-sponsored agencies such as GNMA, the debt of municipal issuers, and some financial institutions as they tend to be tied closely to their sovereign country ratings.
b. The cost of borrowing could also increase for many consumer loans. Loans tied to a U.S. Treasury rate could move higher if interest rates on U. S. Treasury securities rise. This could increase the interest costs of a variety of consumer loans including credit cards, home equity loans and mortgages. Higher interest costs could ultimately lead to lower consumer spending, providing a headwind to the U.S. economy given the consumer represents roughly two-thirds of domestic economic output.
2. Second, other non-U.S. government fixed-income asset prices could be impacted as these securities are typically priced in relation to a comparable maturity U.S. Treasury security. The combination of potential ratings action and the fiscal gridlock behind it could lead to added uncertainty in the financial markets.
3. Third, the U.S. dollar is the world’s reserve currency today, representing approximately 60% of the world’s currency reserves according to the International Monetary Fund. As such, U.S. Treasury securities are held in large quantities by international investors and foreign central banks, in addition to U.S. investors. Investor confidence has been shaken a bit by the U.S. rating downgrade.
4. Fourth, it is a matter of national pride. Being a member of the AAA credit rating club is exclusive. Now only 15 countries can boast of a spotless credit rating.
What are some of the reasons that would help to mitigate these concerns?
1. First, a downgrade from AAA to the AA range (AA+ to AA-) would still leave the U.S. credit rating at a very high level. Other countries with ratings in the AA category range include China, Japan, Belgium and Saudi Arabia. Regaining the AAA credit rating would not be simple to do but it has happened before with both Australia (in the 1980s) and Canada (in the 1990s) having lost AAA ratings and subsequently regaining it. A significant first step for the U.S. to make in this regard would be to put a credible, long-term deficit reduction plan into place.
2. Second, the impact on the market for U.S. government debt may not be as serious as widely thought. We know from Japan’s experience in recent years that bond yields depend primarily on the outlook for short-term interest rates and the factors that determine this outlook, including inflation and growth prospects. Even a decade after Japan lost its AAA rating, ten-year Japanese government bond yields are still only around 1% and the yen is as strong as ever.
3. Third, the U.S. has a much greater dependency on overseas investors owning its securities which leaves it more vulnerable than Japan to capital flight. But there is still no credible alternative to the U.S. dollar as the world’s dominant currency, which means it is as good (if not better) than the home currency for many investors. The fiscal challenges that could undermine the yen are also large, the euro is under serious stress, and the markets for China’s renminbi assets are still years from being sufficiently open to world markets.
4. Fourth, when investors choose to become more defensive and take a lower risk posture, U.S. Treasury securities will continue to be in high demand. The broad-based availability, liquidity, and the backing of the “full faith and credit of the U.S. government”, will continue to be paramount tenets for investors seeking investments with a low credit risk and instant market access.
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