Yesterday, I sent out some general comments about the risk of the US government failing to raise the debt ceiling and defaulting on selected payments; especially if the default becames extended, which would be very problematic but also very unlikely.
However, the more realistic risk (scenario) is that the US government manages to agree to raise the debt ceiling, does not default, but is still downgraded by the major credit rating agencies.
A relatively short-term deal on the US debt ceiling, which does very little to cut spending (or raise tax revenue), might result in a downgrade of the country's long-term debt. Moody’s and Standard & Poor’s have indicated that the failure to produce a longer-term viable solution to the US debt burden indicates that the country's debt is riskier and its credit rating should be downgraded. A downgrade would likely reduce the country’s credit rating by one notch to AA, with a negative outlook.
Hence some general comments of the implications of a US credit rating downgrade:
- The US government has always had an AAA credit rating on its debt, and for many decades US government bonds have been regarded as the world’s ‘risk-free’ asset. Thus a rating downgrade would be unique. 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, would become forced sellers of US government bonds. This would tend to push bond yields higher, even though the total value of these funds are 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 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.
The 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.
- 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.
- The very large, “too-big-to-fail” banks in the US would probably also 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 as being more risky, then so are the banks backed by the US. A downgrade on bank ratings could pose problems for some banks, because it would likely raise their borrowing costs. The more poorly capitalised banks might become more distressed.
- A downgrade of US debt could cause a sell-off on the riskiest side of the bond (especially junk bonds) and on 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 other more risky assets in their portfolio.
- 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 would be expected to continue 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.
- 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”.
Once again, I certainly hope common sense prevails as we head towards 2 August!