Felix TV: Will the US downgrade be a nonevent?

By Felix Salmon
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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Forget Spinal Tap’s “Stonehenge.” A better musical analogy would be The Clash’s “Working for the Clampdown.”

http://www.youtube.com/watch?v=psB0cidB5 bg

The judge said ‘Five-to-ten’ but I say double that again
I’m not . . . working for the clampdown

The men at the factory are old and cunning
You don’t owe nothing, so boy get runnin’
It’s the best years of your life they want to steal

Posted by dedalus | Report as abusive

My guess is that if, in a perfect world, US Treasuries are the ultimate risk-free non-commodity asset and, therefore, the benchmark by which all other asset ratings are judged, then a downgrade would effectively result in a downgrade of all asset ratings, making a downgrade a straw man.

Realistically, if the US were to default, there is no way the World Bank (or any organization, public or private, in which the US is a major contributor/client) could retain it’s AAA rating.

So, effectively, this ridiculous game of chicken currently being played in DC is only going to benefit one group of people – the market makers who set interest rates on bonds. It’s likely those are the very people who screwed the whole world over and had to be bailed out just a couple of years ago.

Oh, the irony….

Posted by ChrisMaresca | Report as abusive

seems to me that the ratings agencies are in a lose-lose situation. They obviously don’t want to be the cause of a global meltdown that could conceivably happen if Treasuries were downgraded to AA which might trigger/force certain funds to divest themselves of Treasuries. Yet at the same time, they’re caught in the trap of needing to stay relevant due to the current course of brinksmanship in Washington.

I think the conditions that Felix & David Gaffen describes is really the best possible outcome for the ratings agencies.

Posted by GregHao | Report as abusive

off topic comment but, felix, can us non hip reuters employee gain access to that nifty screensaver?

Posted by GregHao | Report as abusive

“Johnson & Johnson might have a better credit rating”…

The dollar dominated bonds can’t. I agree that J&J is as close to a riskless credit as you can get… but their debt is still repaid in a currency units. If the U.S. goverment allows the value of its currency to come into question than J&J is not going to tell their creditors hey wow it’s unfair that we just went through 25% inflation over a two year period we’ve decided we really ought to pay you guys 125% of face value upon maturity of our bonds.

If U.S. sovs get downgraded than all dollar denominated corps go with them.

Would be interesting to see if any of the super-corps like JNJ have split ratings like AA for U.S. bonds and AAA for their Euro denominated bonds… seems pretty unlikely to me because really who trusts the Euro more than the dollar. Their both hanging out on the wrong side of town now.

More interesting still would be if Exxon or Total tried to sell some oil denominated bonds. If they did I’m pretty sure they could float a 10 year bond at zero % rate. To buy the bond you pay the spot price on the day it’s issued and you agree to accept the same # of barrel units 10 years in the future. It would be like TIPS only without having to rely on goverment statistics!

Posted by y2kurtus | Report as abusive

“The dollar dominated bonds can’t.”

Isn’t credit rating about default risk, not currency risk?

“More interesting still would be if Exxon or Total tried to sell some oil denominated bonds.”

How is this different from a long-horizon commodity contract?

Posted by TFF | Report as abusive

Isn’t credit rating about defautl risk not currency risk- in theory it should be… but I can’t think of any sov default that did not immeadiatly impact the value of the currency issued by that sov.

Imagine if 1939 era Daimler-Benz issued a bond in old german Marks… even after the war they made the best car money could buy… so their credit risk would have been much better than the defunct goverment. It still would not matter because any bonds issued before the war would be denominated in worthless old marks rather than the new marks issued by the new Allied backed goverment. Credit risk and currency risk are connected at the hip when you’re talking soverign credits.

The Euro presents interesting questions… clearly as long as the hard working germans stick with the Euro it will remain a solid if not stellar currency. European trans nationals like Royal Dutch or Novartis are unquestionably stronger credits than any of the “PIGS” countries, so I guess that’s an example of a corporate trading through a soverign credit… but the Euro is not really a soverign credit the way the dollar, the pound, the frank, or the yen is… none of the Euro member countries can print currency on their own… so the Euro is more of a super-sov.

I’ll stick to my preditcion that if the credit agencies have the balls to call a spade a spade and downgrade the U.S. to AA they will also downgrade all remaining AAA rated U.S. companies. It shouldn’t take long I think there are only 4 or 5 left at this point. That’s why 100% of my modest net worth is in equities volitile though they will be.

Anyway another fantastic topic by Felix… we sure live in interesting times!

Posted by y2kurtus | Report as abusive

Foreign currency risk is a component of the overall credit rating for any given corporate. Obviously USD is not a “foreign” currency so who knows what action the agencies would actually take?

Posted by Tangerinebunny | Report as abusive

“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.”

I’ve been thinking about your closing sentence Felix… Higher interest rates will cause real harm to the tax payers who will pay more to carry public debt at the national and local level.

It’s all zero sum though… tax payer pain is savers gain. The debt crisis artificially and unesscarily lifting rates will be good news for net savers who currently face rates so low that a 60 year old retired couple with a million dollars in the bank technically lives below the poverty line.

Posted by y2kurtus | Report as abusive

“It’s all zero sum though… tax payer pain is savers gain.”

The taxpayers are all US workers and US corporations. The savers are international. For the world as a whole, interest paid equals interest received, but as a country we are a net debtor.

Moreover, higher interest rates stifle capital flow. The only reason for debt in the first place is because the people who NEED the capital are not the ones who HAVE the capital. When debt is cheap, capital flows easily. When debt is expensive, whether due to default risk or inflation risk, capital flows slow to a trickle.

“a 60 year old retired couple with a million dollars in the bank technically lives below the poverty line.”

A 60 year old retired couple with a million dollars of liquid capital would be ill-advised to put it all in the bank. You almost have to keep the bulk of it in equities (hopefully chosen for income and stability, not indexed).

A 60 year old retired couple who converts their wealth to paper currency, stacks it on the front lawn, and burns it is equally living below the poverty line. Fixed income investments are simply a less spectacular way of burning your money.

Posted by TFF | Report as abusive

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