Late Friday Standard and Poor’s downgraded the long-term credit rating of the United States from AAA to AA+ while affirming the nation’s short-term rating of A-1+. For the time being, the US maintains its AAA rating with Moody’s and Fitch. The downgrade stems from S&P’s assessment that the debt reduction agreement reached last week will not stabilize the government’s debt over the medium term. Importantly, the ratings agency identified dysfunction in Washington as a significant factor in its decision, noting that policy making has become “less stable, less effective, and less predictable” than they had previously thought. Reflecting this concern, the agency’s long-term outlook remains negative and it noted that under certain conditions the nation’s credit rating could fall to AA within two years.
Standard and Poor’s indicated that the trajectory of US debt, along with the dysfunction in Washington that inhibits addressing it, was largely responsible for the downgrade rather than the current debt level and the immediate ability to service it. Despite noting that it takes no position on the appropriate mix of spending cuts and revenue increases needed to reduce the debt and budget deficits, it is clear that the omission of new revenue from the agreement played a significant part in the downgrade. S&P’s new base case assumes that the 2001 and 2003 tax cuts remain in place after 2012 while it previously assumed that these tax breaks would expire as scheduled and result in $950 billion in additional revenue.
In assessing the long-term implications of the downgrade, one must ignore the political rants from our elected officials and assess economic and financial realities. In the absence of a return to recession, interest rates are likely to rise significantly over the next six to 12 months. Not due to the downgrade, but rather due to the fact that they are currently overvalued after a six month rally that has seen 10-year yields decline from 3.71% down to 2.34%. To some degree this is due to the slowing pace of recovery, but it is also due to risk aversion that seems likely to lift over the next few months. Despite the downgrade, the US will continue to fund its debt on very easy terms in the immediate future with the risk being in the longer-term. First, prior to the downgrade, the US accounted for about 55% of all AAA rated sovereign debt outstanding. France accounts for 11%, the UK and Germany 10% each, and Canada another 4%. Nations with current account surpluses and large foreign currency reserves to invest in high quality sovereign debt have a rather limited opportunity set, as do insurers and pensions seeking high quality long duration assets to match their liabilities. The limited opportunity set and the fact that US debt remains very high quality means it will remain well bid.
Additionally, the UK, France and Germany possess significant risks of their own. Debt as a percentage of GDP is currently higher in the UK than in the US and it will be higher in France by 2015 by S&P’s own estimates. Governments in the UK and France do not appear as dysfunctional as that of the US. Yet despite the economic weakness here at home, our economy remains more dynamic that that of either the UK or France. Meanwhile, Germany and France are burdened with the heavy lifting required to bailout troubled Eurozone members. In short, the three largest alternative soveriegn issuers face daunting challenges of their own. As such, it’s hard to argue that their debt is significantly more attractive than that of the US despite their modestly higher ratings. In short, the demand for high quality assets coupled with an extremely limited opportunity set will result in continued strong demand for US Treasuries in the immediate and intermediate future.
Meanwhile, a number of nations whose currencies have appreciated dramatically against the US Dollar are likely to continue to buy US Treasuries as they attempt to limit further currency appreciation. Many export dependent nations have been concerned about the appreciation of their currencies, which reduces the price competitiveness of those exports. Japan, the second largest foreign purchaser of US debt behind China, intervened in currency markets last week, attempting to stem the tide of Yen appreciation. China too will continue to buy Treasuries as it tries to control the pace of Yuan appreciation. While the Chinese may reduce purchases at the margin, purchase they will. Other nations may also reduce purchases at the margin, but there will not be wholesale selling of US Treasuries. Simply put, even if the Treasury market were not the most liquid market in the world for high grade debt, it doesn’t make sense to liquidate a large inventory of high quality debt simply because its rating has declined modestly from AAA to AA+.
Furthermore, the breath and depth of the Treasury market makes it the asset class of choice when bouts of fear push investors into “risk off” mode. Such episodes have occurred on multiple occasions since the markets for global risk assets bottomed in March 2009 and they are likely to continue to occur for many years as the global economy goes through a tumultuous rebalancing process. Treasuries will likely continue to rally when investors choose to reduce portfolio risk over the next three to five years. Despite the US debt ceiling debate being front and center (along with the European debt crisis) we have experienced a massive rally in Treasuries since the end of April. Despite the downgrade, investors in US Treasuries will continued to receive interest and principal in a timely fashion and US debt will continue to carry far less downside risk than global equities, commodities, or most other credit instruments. It is also the largest market of its kind and therefore the most liquid. As such, it will remain the asset of choice when investors choose to reduce risk.
Moderate economic growth, the massive liquidity of the US Treasury market, concerns about the quality of debt issued by similarly rated sovereigns, and massive holdings by nations with current account surpluses, are likely to result in continued demand for US Treasuries, resulting in favorable funding conditions. Sadly, that may actually pose the greatest risk of all if our elected officials mistakenly take it as a symbol that the capital markets approve of their intransigence. Being the best available option is not the same thing as being an excellent one. Hopefully, Washington will take the downgrade as a signal that it must intensify its efforts to produce a viable debt reduction plan. Like it or not, any rational analysis indicates that this will require both significant spending cuts and higher revenue, either through higher tax rates or, better yet, a significantly reformed and simplified tax code that eliminates many of the deductions enjoyed not only by corporate America, but by individuals as well.
Importantly, we the people must take responsibility for the government we have elected. We must accept that the issues we face are dynamic and not prone to simplistic answers that can be summed up by a campaign slogan or sound bite. We need to elect representatives that tell hard truths that we may not enjoy hearing and that offer detailed solutions that will likely have some negative impact on each of us. So too must we realize that the challenges of not only rebuilding our own economy, but of rebalancing global trade and finance, are daunting and fraught with risk. Changes that benefit one nation may negatively impact some of its trading partners. An appreciating currency benefits a country’s importers while negatively impacting its exporters (especially when those exports are dependent upon being a low cost provider rather than a product differentiator). Currency appreciation can also help limit inflation, especially in nations that import significant amounts of commodities, the vast majority of which trade globally in US Dollars. The size and scope of these challenges, varying speeds of recovery, and the varying levels of economic dynamism raise the specter of trade battles and increase the risk of policy mistakes. While governments have tried valiantly to work with one another over the past three years, it is likely to become harder for them to do so as the global recovery continues to be a multi-speed affair.
The downgrade of US debt is not nearly as significant as how we address our spending habits and revenue needs moving forward. That will determine whether the nation stabilizes its debt as a percentage of GDP and eventually returns to AAA status or whether it suffers further downgrades. Despite the modest impact the downgrade is likely to have on the cost of funding our nation’s debt, the analysis of this situation highlights some of the very real risks associated with the global rebalancing that remains ahead.