Yesterday after the U.S. markets closed, Standard & Poor’s downgraded their credit rating on U.S. government bonds. Previously, the U.S. government had enjoyed for over 70 years the highest possible rating: AAA. Now it is “only” going to be AA+. We should note that the other two major bond-ratings agencies, Moody’s and Fitch’s still rate U.S. debt as AAA. So what does this mean? Does it reflect poorly on the U.S.? Not really. It’s all a farce and it reflects poorly on Standard & Poor’s.
There are many reports in the news, especially in local newspapers and by non-economics reporters, to the effect that this downgrade means higher interest rates. Some have even suggested that everyone in the U.S. including individuals and corporations and states will pay higher interest rates. That’s all nonsense. Not only is a national government not like a household or firm, but bond ratings for governments don’t work like credit ratings for individuals. If you credit score as an individual (those things called FICO scores), then when your credit rating is downgraded you pay higher interest rates for car loans, mortgages, and credit cards. When governments get downgraded, especially from AAA to only AA+, it doesn’t directly affect interest rates. Government debt interest rates aren’t really “set” by anybody. Government debt interest rates are the result of market auctions of the bonds. If demand for the bonds increases, then prices rise. In bonds, prices are the inverse of the yield, or interest rate. When prices go up, then interest rates have effectively gone down.
Lately U.S. Treasury yields (interest rates) have been dropping. They’ve been dropping regardless of whether you compare now to 3 months ago or just 2 weeks ago. They’ve been dropping regardless of which maturity (3 month, 6 mo, 2, 5, 10,or 30 year) you look at. This means that bond prices have been rising. That means there is more demand for U.S. Treasuries. Not exactly the story of default and risk that S&P maintains, right? Right.
U.S. Treasury Yields
Q:What’s the difference between AAA and AA+? That doesn’t sound so bad.
A: It’s not so bad — and there’s not much difference. Technically, AA+ is considered “high grade” credit, while AAA is “prime.” The likelihood of getting paid back by a AA+ credit is considered “very strong,” while a AAA credit’s likelihood of paying you back is “extremely strong.” See the difference? Me neither.
And the U.S. is a special case, given its status as the world’s largest economy and printer of the world’s reserve currency. If your personal credit score falls, then you will almost certainly have to pay more to borrow. The U.S. can get away with a slight credit-rating downgrade without having to pay more to borrow. In fact, many other large, developed economies, including Japan, Canada and Australia, have lost AAA ratings in the past and not had to pay more to borrow in the long run.
Q:Luxembourg is rated AAA. Is the U.S. really a worse credit risk than Luxembourg?
A: No way. Luxembourg is a great country and a perfectly sound credit risk, but it lacks many of the advantages of the U.S., including the aforementioned economy and reserve currency, along with a very large printing press for that currency. If anything, this downgrade exposes some of the other discrepancies in ratings around the world. Should bonds issued by the European Financial Stability Facility, the entity set up to help bail out European sovereigns, really have a AAA credit rating, for example?
Q:Won’t some investors be forced to sell because of even this small downgrade?
A: Maybe, but not very many. Given the liquidity and relative safety of Treasurys, many regulators and money managers put Treasurys in a special category apart from rating considerations. Other managers are considering tweaking their rules to allow them to keep Treasurys.
U.S. banking regulators have confirmed that the downgrade will not force banks, which have big Treasury holdings, to raise any more capital as a cushion against losses. Short-term Treasury ratings weren’t affected, so money-market funds won’t have to sell
Q:What about foreign investors? Surely they’ll sell.
A: Probably, but they may not sell much. They’ve been trying to diversify their holdings for years, but they keep running up against an impregnable hurdle: They’ve got nowhere else to go. For better or worse, Treasurys are the largest fixed-income asset class in the world, by far, and the likelihood of default is next to nothing. The dollar is, for now at least, the world’s reserve currency, meaning foreign central banks will have to keep buying Treasurys. There’s really no other alternative available.
Q:What is the likely effect on interest rates, then?
A: Very hard to say, given all the cross-currents affecting markets right now. In a perverse sense, this downgrade has come at just about the best possible time for the U.S., despite the turmoil in the markets and anxiety about the economy. Those very uncertainties have driven investors around the world — including foreign central banks — to the safety of U.S. Treasurys, pushing U.S. borrowing costs to nearly their lowest levels in generations. So any increase in rates will come off a very low base. If interest rates rise half a percentage point, for example, that might put 10-year Treasury yields at 3% — still an extraordinarily low rate.
What’s more, the market has been bracing for this downgrade for a while, particularly on Friday, when rumors of it were widespread. It’s possible that most of the increase in yields has already happened. In any event, the history of Japan, et al, suggests that a downgrade might have no long-term impact on borrowing costs at all. Investors will likely respond more to inflation pressures, the direction of short-term interest rates and economic growth than to what one or more rating agencies say.
Remember that S&P are the same folks that told us that bonds backed by sub-prime mortgages were AAA a few years ago. They are the same people that rated Lehman Brothers debt as “A” the night before Lehman declared bankruptcy. They are the same people that downgraded Japan over 10 years ago and yet Japan still pays lower interest rates on government debt than the U.S. despite having a debt-to-GDP ratio of over 200%, more than twice the U.S. S&P has no special knowledge of the U.S.’s financial position that you don’t have access to. They get all their data from the news too.
I really do not expect much direct impact from S&P’s decision on financial markets. It may cause some temporary churn and increase volatility as a few funds might find they are legally required to sell because they must legally only own AAA bonds, but event that’s not likely. I’m not alone in my prediction here either. Yves Smith at NakedCapitalism and others share my view. Fortunately banks have been told that the rating change will not affect how bank capital requirements are calculated. Quoting the Wall Street Journal:
Late Friday, federal regulators said the downgrade wouldn’t affect risk-based capital requirements for U.S. banks—the cushion banks must hold to protect against losses. The Federal Reserve, Federal Deposit Insurance Corp. and other federal banking regulators said in a statement the lowering “will not change” the risk weights for Treasury securities and other securities issued or guaranteed by the U.S. government or government agencies.
If you believe S&P, then you must believe that Luxembourg and Leichtenstein are more secure, more powerful economies with a brighter future than the United States.