“We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation does not begin by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.”
– S&P in April, explaining the decision to change its outlook on the US long-term rating from stable to negative.
And now…
“The debt ceiling is not the central preoccupation that we have. We put the United States on credit watch because we’re growing less certain that this political debate can be resolved. This was not merely about the debt ceiling.”
– David Beers, director of the sovereign debt division at S&P, speaking to The Atlanticlast week.
So much for waiting until 2013. The muted response of the markets this morning to the ongoing stalemate in the debt ceiling negotiations suggests the prospect of a default is still remote.
The probability of a downgrade, however, appears only to have increased, with seemingly every sell-side research shop rushing out notes on the potential impact on every fixed-income asset class tied to US government support.
It may not have been “merely” about the debt ceiling, but it’s worth emphasising again that the decision by the credit rating agencies to start making noises about a possible US downgrade even if a debt ceiling deal is reached has been based on their reading of the political situation. And that reading has come about primarily because of the debt ceiling impasse — or to be more accurate, because the debate over how to reform the deficit became intertwined with that of the debt ceiling.
There’s something perverse about all this. Markets haven’t been worried — and still aren’t worried — about the deficit in the near-term at all. Rather, the debt ceiling has revealed a political process the rating agencies have interpreted as too paralytic to get anything done about problems that are not yet urgent.
Look, it’s really difficult to know what the political system will look like by 2013, or any way to know how even forseeable issues will turn out — like what will happen, for instance, to the Bush tax cuts. While we can’t imagine that the state of US politics will be any prettier by then, it’s a hard hypothetical to anticipate with any confidence.
Even more important, we’ve no idea how the economy will be performing then, or what kind of future trend it will be following — which if not as important to the health of future budgets as the political process, is surely a huge part of it.
Our point here isn’t even that the rating agencies would be wrong to downgrade the US. Minding politics, and including forecasts in their ratings, is part of their job.
What we question is why people would think the rating agencies are better at doing this than anybody else, at least given how transparent the government’s books are when it comes to its debt profile. In the present circumstances, a downgrade would tell us (and the markets) precisely nothing new. It’s the downgrade itself that would be the big news.
So we won’t shed any tears if the outsized role of the rating agencies continues to be trimmed, or if more generally they lose relevance in global debt markets — the sooner the better.
But that won’t happen for a while — and what matters now isn’t what we think about how the rating agencies go about their business, but how markets and the economy would react. And we note an awful lot of hubris in most efforts to predict what the fallout would be from a downgrade.
We think that very few investors will be forced to sell and few others will choose to sell strictly because of a rating downgrade to double-A. In Figure 2 we show the broad categories of Treasury ownership.
We will split the above categories into five groups to discuss likelihood of reaction to a downgrade to double-A.
Household, Corporate & Government — Domestic households, corporations and government entities (including the Fed) are unlikely to sell a meaningful amount of Treasuries on a downgrade to double-A. Most of these entities will have very US-centric portfolios and the lack of alternative US triple-A securities will likely result in investors maintaining Treasury holdings.
Financial Institutions — US Banking and insurance institutions are also unlikely to want to sell due to a downgrade to double-A. There is also no risk weighting impact of this type of a downgrade under any of the Basel frameworks. A downgrade into the single-A category could potential motivate sales from these institutions based on Base II/III. However, this is extremely unlikely in the near-term absent a technical default.
Money Managers — The majority of money managers will not sell due to a downgrade to double-A. Keep in mind that most are index benchmarked and the change in their benchmark would mostly mirror the change in their assets, absent an overweight to the assets that are downgraded.
Money Markets — Under a downgrade scenario to double-A it is expected that the US would continue to hold a short-term ‘A-1+’ rating which would mean that US Treasuries remain first tier securities. Therefore, we would expect that there would be limited selling of short-term Treasuries by money market funds.
Foreign Official — Central Bank and Sovereign Wealth Funds are likely to modestly sell and modestly reduce future purchases of Treasuries. We think that very few would be forced sellers at the double-A level — although some potentially could be. However, we think that this would forever change the view of US Treasuries as a riskless asset. In practice, this type of an action would likely slightly accelerate the diversification out of US Treasuries into other assets that have been under way for decades.
Other Foreign — We expect that there would be few forced sellers, but more sellers by choice in this category. It is more likely that these investors are in out of benchmark investments and these investors are certainly non US centric. While foreign financial institutions may have many of these securities matched versus US dollar liabilities, many investors are likely to look at other triple-A assets worldwide as a substitute.
All seems very persuasive, even encouraging. And maybe Citi is right.
But there are other possibilities here. Yields could spike, and one possible trigger would be widespread portfolio rebalancing, caused not by forced selling of Treasuries but simply by investors trying to find a new understanding of what constitutes a risk-free security. In other words, some of the pressures that would result from a default could still apply to a downgrade. That’s before we get into the negative feedback loop that would result from whatever damage is done to repo markets and other markets where US Treasuries are used as collateral.
But the opposite may happen, with market turmoil caused by worries about US government debt leading investors to pile into… US government debt, driving rates down still further. This would especially be true if investors agree with us that they’re not learning anything new from a downgrade, or if a downgrade is already priced in by the time it’s actually announced. Remember that only the longer-end bonds would likely be downgraded, so maybe there simply would be effects of varying funkiness throughout the yield curve.
Or maybe nothing at all will happen.
All of these are possible, and it’s not easy to assign probability weights to any of the outcomes.
But perhaps the biggest problem with efforts to think through this scenario is that they all exhibit a mechanistic way of thinking — this leads to that. To some extent this can’t be avoided, and we do it ourselves here all the time. But given the size and connectivity of the US Treasuries market this seems like an instance where events are unlikely to neatly unfold. The interplay of so many variables probably means a future that can’t be known before it gets here, and might not be properly understood even once it is here.
