Sat, July 16, 2011
Washington’s Delays On the Debt Ceiling Could Roil Financial Markets
The continuing impasse between Democrats and Republicans on raising the US debt limit before August 2nd prompted a major ratings agency to place the nation’s AAA rating on credit watch this week, suggesting that the rating might be lowered even without an outright default.
Standard and Poor’s action is a warning that the nation’s credit rating could be lowered by one or more notches within the next 90 days. In its report, S&P stated that there is at least a 50% likelihood that it will lower the rating, noting that it “may lower the long-term rating on the U.S. ... if we conclude that Congress and the Administration have not achieved a credible solution to the rising U.S. government debt burden and are not likely to achieve one in the foreseeable future.”
The Meaning of A Lower Credit Rating for Treasury Debt
The coveted AAA is the highest rating issued by S&P; the US is one of about 20 sovereign credit issuers rated AAA. Bonds and other securities that are rated AAA require the lowest interest rates for a given type of debt, because they are considered very safe. Under normal circumstances, a rating reduction would cause the interest rates that buyers demand for the securities to rise, in turn causing the market value of existing similar bonds to decline somewhat. While estimates are that rates might only rise 0.25% if the US were to lose its AAA rating, such a change would raise serious doubts about the nation’s economic and political soundness.
Although S&P considers it unlikely that the US will default on its debt obligations, the action reflects S&P’s concern that because of the lack of agreement on the debt problem, any likely solution will not result in a long-term reduction of the US deficit. In its report, the agency stated, “We may also lower the long-term rating and affirm the short-term rating if we conclude that future adjustments to the debt ceiling are likely to be the subject of political maneuvering to the extent that questions persist about Congress’ and the Administration’s willingness and ability to timely honor the U.S.’ scheduled debt obligations.” A short-term rating reflects the risk of a default within a year.
The Effect of a Downgrade on Financial Markets
The loss of the AAA rating would be expected to increase US borrowing costs in the long-term. While the change would not affect American corporate bond ratings directly, there’s a good probability that Treasuries, agency bonds, federally guaranteed mortgage debt, and municipal bonds linked to the federal government (e.g., Buy America Bonds) would all be included in the downgrade. This would affect about 70% of all bonds in the Barclays Capital US Aggregate Bond Index, one of the major US bond indices.
It’s difficult to predict how financial markets would react to a major downgrade of US debt. Markets have a perverse ability to remain optimistic in the face of all sorts of bad news. But with the existing weaknesses in housing, employment, state finances, and the global economy, it’s difficult to believe that the financial world would not react badly to a US sovereign debt downgrade. Investment management firm PIMCO’s Mohamed El-Erian believes that if the impasse is not solved and the Treasury has to start deciding which bills to pay, “we will be in the land of the unpredictable.” The entire global financial system would need to realign in order to respond to a drop in the US credit rating.
Anticipating a Downgrade
Financial markets don’t like uncertainty. Although investors usually flock to US Treasuries during periods of financial instability, it’s tough to be confident that that would happen in the event of a downgrade. Treasuries might fall, or stocks and other risky assets could decline instead. There would probably be a lot of initial confusion in the markets.
Foreign nations, which own about one-third of US Treasury debt, might actually start backing out of their holdings, sending yields up further – but that is an unlikely outcome, as they would risk precipitating a sudden drop in the value of their own holdings. More likely, as PIMCO’s Bill Gross noted in the Washington Post this week, is the chance that a downgrade would make foreign nations less willing to conduct their business dealings in dollars.
Moreover, there is one “wild-card” risk if US sovereign debt is downgraded. Some types of investors – certain types of money market funds, pension funds, and other institutional investors – have internal rules that oblige them to keep a specified portion of their assets in AAA-rated debt. If Treasury debt loses its AAA rating, no one is really sure what these investors would legally be able to do - would they dump their US debt holdings in a hurry? That seems unlikely, but it’s something that has never been considered before, since it wasn’t that long ago that it would have seemed inconceivable for US debt to lose its AAA rating.
Investors with funds that they plan to spend in the next year or so would be wise to keep their money in FDIC-insured accounts or else avoid any but the shortest-duration Treasuries and agency securities. While investors in US debt obligations are extremely unlikely to experience a default, the prices of Treasury debt and the mutual funds that hold them could go through some unpleasant blips before things stabilize. That isn’t an environment in which you’d want to have to sell your securities.
For longer-term investing, if you have doubts about Washington’s ability to make a serious dent in the deficit, you may want to read Russ Koesterich’s “The Ten Trillion Dollar Gamble” for ideas on how to invest long-term in the face of likely economic distress and higher inflation.
