A few, final thoughts on the negative outlook for the USA from Jan Hatzius and his team at Goldman Sachs.
First they look at the somewhat confusing market reaction — Treasuries were remarkably resilient following the move by S&P:
Increased downgrade risk doesn’t necessarily imply increased Treasury yields.
Immediately following the announcement, the 10-year Treasury yield rose by around 6bps. However, Treasuries subsequently rallied, with the 10-year finishing the day at a yield 3bps lower. While the modest rally in Treasuries can probably be attributed to a number of factors, potentially including concerns regarding fiscal issues in the European periphery, it is worth noting that:
(1) a significant push toward fiscal austerity would lead to lower growth and
(2) lower growth would lead to easier monetary policy for longer. As outlined in more detail in a recent report, fiscal tightening of 1% of GDP has been associated with reduced output of 0.5% within two years, but would also tend to keep short-term policy interest rates lower than they would otherwise have been.
The upshot is that while most of the commentary around potential ratings changes is likely to focus on the potential increase in yields as compensation for perceived credit risk, the policies that would need to be pursued to avoid a ratings change could push in the opposite direction.
So lower for even longer then.
And then Team Hatzius compares the US with other developed nations and concludes the country is already at the outer edge of AAA territory:
Two factors that rating agencies such as S&P and Moody’s use in their analyses are the ratio of net debt to GDP and the ratio of net interest payments to government revenues. In both cases, the ratings typically reflect “general government debt,” a definition which covers all levels of government, including state and local governments in the US, for instance. In the case of the US, most of the net debt—and most of the rating agency concern—is at the federal level. The first exhibit below compares the US to other AAA-rated countries as well as a select group of AA+ to AA- countries for which cross-country data is available. It implies that the US is already at the outer edge of AAA territory.
A graphic that will no doubt warm the heart of UK chancellor George Osborne.
Recall that S&P revised its sovereign outlook for the UK to negative in May 2009. That stance was reaffirmed a year and a bit later, before it was revised back to stable in October 2010 after the government had completed its comprehensive spending review.
So, it is possible for the US to win back a stable outlook but, says Hatizus, a reform package would probably need to be adopted before the outlook would be changed:
While enactment of major structural reforms to entitlement programs or the tax code look challenging in the next year, the announcement from S&P may on the margin increase the likelihood that Congress enacts one or more fiscal rules along with the increase in the debt limit, which we already viewed as a good possibility. The most likely change would be discretionary spending caps, which could apply for multiple years and would be difficult to undo once put in place.
A second possibility is some version of the “failsafe” concept that President Obama proposed last week, which would require automatic reductions in spending and “tax expenditures” if by 2014 the debt to GDP ratio has not yet stabilized and is not projected to decline in the second half of the decade
And then one has to be wary of tightening too much, something that probably keeps Mr Osborne awake at night.
Or at least should:
A second important lesson from the UK episode is that while S&P put its sovereign rating on negative outlook, other agencies acted differently. Moody’s, for instance, declined to change its outlook on its UK rating in 2009 or 2010. In contrast, Moody’s has recently indicated increased concern about the UK fiscal position in part due to slower than expected growth that has been a byproduct of fiscal tightening.