Felix TV: Will the US downgrade be a nonevent?

July 27, 2011

How disastrous is the increasingly-inevitable downgrade of US sovereign debt going to be? I talked to David Gaffen about this yesterday, and he reckons it’s probably not going to be such a big deal. And he’s backed up today with a report from Fitch Ratings, behind a registration wall here.

The fact is that Treasury bonds are going to remain the global fixed-income benchmark, simply because there’s no alternative. There are $9.3 trillion in marketable Treasury securities outstanding — that’s five times the debt stock of triple-A countries like France, Germany, or the UK. And when it comes to liquidity, the gap is even bigger: daily Treasury volume of $580 billion is 17 times higher than the next most liquid triple-A security, UK gilts. And UK gilts are denominated in pounds, which is hardly a global reserve currency; they’re certainly not much use for, say, financial institutions needing collateral for their dollar-based triparty repo transactions.

Oh, and one other thing: it turns out that beyond mystique-and-aura, there’s really no substantive difference between triple-A and double-A anyway: “the long-term credit performance of ‘AAA’ rated versus ‘AA’ rated issuers,” says Fitch, “is statistically negligible”.

So I’m willing to go out on a limb here, and declare that even if the US gets downgraded, Treasuries will still remain the lowest-yielding securities in the world. Triple-A issuers like the World Bank or Johnson & Johnson might have a better credit rating, but they’ll still have higher borrowing costs and higher yields than the US government. At these rarefied levels the liquidity of Treasuries is vastly more important than whatever negligible difference in credit risk there might be between the US and someone marginally safer.

That said, even Fitch concedes there will be “near-term volatility” in the immediate aftermath of a downgrade. On top of that, the repercussions for things like muni bonds, which will get downgraded at the same time, are much less predictable. And over the long term, people are going to think for a little bit before rushing to Treasuries as the ultimate safe haven. And investors hate being asked to think. Have no doubt: this entirely avoidable downgrade will increase US borrowing costs. A downgrade won’t end the primacy of the Treasury market. But it will still cause real harm.


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