Saturday, August 6, 2011

S&P Downgrades U.S. to AA+: So What?


Late Friday evening, S&P downgraded the U.S.’s long-term debt rating to AA+ with a negative outlook. If that downgrade has no economic impact, it will fade from the headlines. And that is the most likely scenario.

The downgrade should come as no surprise. On July 25, The Daily Beast quoted me as saying that a downgrade was “inevitable.” And since I am not on Wall Street, I am confident that I was among the last to come to that conclusion.

After all, S&P was telegraphing that it would downgrade the U.S. for weeks when it said it would do so unless it saw a plan to cut the deficit by $4 trillion. Late last month it became quite clear that there would be no plan that big. So investors’ only uncertainty regarding S&P was whether it would follow through on its threat — and it did so, albeit a week later than anticipated.

Behind S&P’s downgrade is an economic model of the U.S.’s fiscal state over the next decade. That S&P model uses a Congressional Budget Office projection of $2.1 trillion in budget reductions over 10 years from the recently passed debt ceiling deal to forecast a rise in the U.S.’s net general government debt-to-GDP ratio.

The U.S.’s ratio is forecast to rise above those of governments that are retaining their AAA rating. Specifically, S&P forecasts that the U.S.’s debt-to-GDP ratio will increase steadily from 74% (2011) to 79% in 2015 and 85% by 2021.

Interestingly, AAA-rated governments — including Canada, France, Germany, and the U.K. — do better than the U.S. in some cases and worse in others. For example, Canada is the world’s healthiest AAA-rated government with debt-to-GDP of 34% in 2011 and 30% in 2015. But the U.K. is worse off than the U.S. in 2011 (80%) and France, with 83% is worse off in 2015.

The difference in S&P’s view between the U.S. and the U.K. and France is that it forecasts that our debt-to-GDP ratio will keep going up by 2021 whereas their ratios will start to go down by 2021.

Wall Street operates on the gap between expectations and reality. And S&P’s decision should come as no surprise. The only question is whether any institutions will be required by their charters to sell U.S. treasury securities now that S&P no longer rates them AAA.

Some public pension funds and mutual funds may be required to sell U.S. treasuries. My guess is that will amount to sales of 3% of their combined U.S. treasury holdings — assuming that those funds did not sell them in anticipation of S&P’s move. For most investors, an S&P rating is not the critical factor in their investment decisions.

Meanwhile, assuming S&P’s move had been anticipated by the markets, one would expect to see higher interest rates in the U.S. and lower interest rates in the AAA-rated countries. That’s because prudent investors would be dumping U.S. securities and buying securities in AAA-rated Canada, France, Germany, and the U.K.

As it turns out, that is not quite what happened. Instead, rates tumbled in the U.S. and in all the other countries and the U.S. ended last week with the third-lowest 10 year bond yield of its peers — just slightly higher than those of the world’s healthiest AAA-rated country, Canada.

Here are the sizes in trillions of dollars of the five countries’ marketable treasury securities markets along with changes to their 10-year treasury yields between July 1 and August 5:
Not surprisingly, big investors who set these rates are coming to a different conclusion than S&P. The U.S. treasury market is over four times bigger than Germany’s. And for investors like China — that own $1.1 trillion in U.S. treasuries – that superior size offers a comforting level of liquidity.

For all the joy that some take in S&P’s decision to downgrade the U.S., global investors passed their verdict on the U.S. before S&P’s late night press release — by lending the U.S. money for 10 years at a 19% lower rate than they did a month ago.

It remains to be seen whether all the weekend huffing and puffing will change that.

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