S&P decided, on 5 August, to lower the US’s Long-Term Credit Rating to 'AA+' from ‘AAA’. The outlook for the rating is Negative.
Summary points made by S&P in deciding to downgrade the US:
- The downgrade reflects S&P’s opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to (on 2 August 2011) falls short of what, in their view, would be necessary to stabilise the government's medium-term debt dynamics.
- More broadly, the downgrade reflects S&P’s view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges. The weakness is at a higher degree than they envisioned when they assigned a negative outlook to the rating on 18 April 2011.
- Since 18 April 2011, S&P have changed their view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes them pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement last week into a broader fiscal consolidation plan that stabilises the government's debt dynamics any time soon.
- The political brinksmanship of recent months highlights what S&P sees as America's governance and policymaking becoming less stable, less effective, and less predictable than what they previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy.
- Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee the decisions on more comprehensive measures.
- S&P is of the opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising US public debt burden in a manner consistent with a 'AAA' rating and with 'AAA' rated sovereign peers.
- The outlook on the long-term rating is negative. S&P could lower the long-term rating to 'AA' within the next two years if they see less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period, as these would result in a higher general government debt trajectory than they currently assume in their base case.
On 29 July, I sent out some general comments that discussed the possible impact of a US rating downgrade. Those comments still apply, and perhaps the following points are worth highlighting:
- The US government has never not had a AAA credit rating on its debt (S&P assigned the US a AAA credit rating in 1917), and for many decades US government bonds have been regarded as the world’s ‘risk-free’ asset. The rating downgrade is therefore a unique event. Hence the financial market implications of a US rating downgrade are largely unknown.
However, when Japan lost its AAA rating status in 2001/2002 (S&P downgraded Japan's credit rating in 2002), many analysts were extremely concerned and argued that Japanese bond prices would fall sharply and interest-rates would rise. They did rise, but far less than most analysts expected, and have actually performed relatively well since, despite the massive accumulation of debt.
- Some institutional investors are required to hold only AAA rated credit instruments. These investments, which are mainly public pension funds in the US, will become forced sellers of US government bonds. This will tend to push bond yields higher, even though the total value of these funds is relatively small in the context of the US national debt.
- Although foreign central banks hold a significant portion of US debt (mainly China and Japan) they are unlikely to aggressively sell a significant portion of their holdings as they would recognise that a sharp rise in US bond yields would undoubtedly hurt their own asset base, as well as the chances of a sustained US/Global economic recovery.
There are also not many practical alternatives to holding US government bonds. Germany, mainly as a result of its fiscal discipline, lacks the volume and liquidity of debt instruments required to rival the US, and most other European sovereign bonds seem riskier than the US. In addition, Japan remains the most indebted country in the world.
This recognition of the importance of maintaining low bond yields in the US, especially while the global economy is trying to recovery more fully from the Credit Crisis, would apply especially to other G20 Central Banks. They may, however, look to continue to slowly diversify their currency and debt exposure away from the US, while being out-spoken and critical of the US.
- German bonds would most likely rally, at least on a relative basis to US debt, in the event of a downgrade. Some investors will seek shelter and diversification, and Germany is one of the few nations that can offer a safe alternative to US bonds. The relative small supply of German debt could, however, lead to an over-valuation of German bonds.
- Gold is likely to continue to benefit from the increased uncertainty.
- The very large, “too-big-to-fail” banks in the US will probably also eventually get downgraded, following the downgrade of the US credit rating. The ratings of these banks currently benefit from the belief that they will be bailed out by the US government if they get in trouble. If US debt is regarded are being more risky then so are the banks backed by the US. A downgrade on bank ratings could pose some problems for a few banks, because it would likely raise their borrowing costs.
- The downgrade of US could cause a sell-off on the riskiest side of the bond (especially junk bonds) and stock markets. Some fund managers may decide that because their portfolios are a little more risky as a result of the downgrade, they need to counter this increased risk by selling the more risky assets in their portfolios.
- Credit markets may become less efficient. US bonds are used as collateral in many credit transactions. A downgrade could mean that credit transactions require more of the downgraded bonds as collateral. This could slow some transactions and make markets less “efficient” than they might be otherwise.
- The US Dollar is expected to weaken (at least in the short-term) and it is likely that the Swiss Franc remains the main beneficiary. However, I would not bet on a sustained weakening of the Dollar, simply because the Euro is facing its own extreme difficulties and the world’s financial economy is not in a position to replace the role of the US. In addition, currencies such as the Swiss Franc and Japanese Yen are already extremely strong and their authorities are likely to take further measures to weaken their currency.
- The US Federal Reserve would most likely respond to the downgrade by indicating that it will continue to accept US bonds as collateral for every type of transaction, including the discount window. They could also consider QE3, as a mechanism for buying bonds from any "forced sellers”. A sustained rise in US bond yields would create anxiety over the sustainability of the US’s fragile economic recovery
- The performance of emerging market assets is a little unclear. One argument is that the downgrade leads to increased risk-aversion and hence a sell-off of emerging markets assets, including the Rand and SA equity market.
However, there is a growing recognition that the fundamentals of many emerging economies remain sound; especially low levels of government debt. This could imply an ongoing diversification away from developed markets and into emerging economies, including South Africa. So perhaps there is an initial negative reaction in the local market, exacerbated by global uncertainty, but perhaps that is later replaced by a more fundamental investor approach.
The downgrade of the US is not a complete surprise. S&P provided a clear warning ahead of the US’s debt ceiling fiasco. Moody’s and Fitch have been more sanguine, opting to maintain the AAA rating, but have also indicated that the US rating has a negative outlook.
The downgrade happens at a very unfortunate time, given the fragility of the global economy, especially the extreme difficulties in the Euro-area. This is likely to exacerbate any market weakness and volatility, especially early in the week. Ultimately, it is not currently possible to replace the role of US in the global financial system, and that while investors, central banks, business etc will continue to diversify away from the Dollar and the US economy will continue to play a less important role in the global economy, this diversification and shift in economic power takes time.