U.S. downgrade could arrive as a whimper

July 27, 2011

A potential downgrade of U.S. Treasury debt by a credit ratings agency, once seen as impossible for the world’s largest economy, could resound in financial markets more with a whimper than a bang. That’s because, as was evident in a Reuters poll, investors have largely come to expect it.

That Standard & Poor’s ratings agency will cut the U.S. debt rating from AAA to AA+ is “the market’s base case at the moment,” said Krishna Memani, fixed-income director at OppenheimerFunds, with $188 billion in assets under management.

The market does not expect a significant, long-term deficit reduction plan that would keep S&P from cutting the U.S. debt rating.

For markets, in other words, a U.S. debt ratings downgrade might not be that newsworthy, landing with a dull thud rather than a cataclysmic crash. Argues Daiwa Securities Chief Economist Michael Moran:

Market participants have the same information that ratings agencies do and are forming their views and expectations on the creditworthiness of the U.S. Those views should already be reflected in interest rates.

Consequently, a U.S. debt ratings downgrade would not cause yields to skyrocket, limiting the so-called “knock-on” effects on other kinds of interest rates like mortgages. How Treasury rates have behaved during the past couple of weeks of acrimonious budget talks is illustrative, says Moran:

A downgrade by a rating agencies would be following the market, rather than leading the market. Treasury rates have not fluctuated very much with the ebb and flow of the budget negotiations. Breakdowns in talks have not sent rates markedly higher and potential breakthroughs have not pushed rates noticeably lower. This lack of response suggests that investors have already built in some longer-term views on the credit worthiness of the U.S.

The political process, not an action by a debt ratings agency, is informing investors’ decisions, said Alan Ruskin, head of G10 FX strategy at Deutsche Bank.

We’re learning all the time about whether our divided Congress has the capacity for the give and take that will be needed to reach an overarching, large-scale resolution on debt issues.

In fact, a prospective U.S. debt ratings cut may do less to drive market sentiment than a weak economy whose growth prospects remain highly uncertain, said Memani at OppenheimerFunds.

The uncertainty supports Treasuries and hurts the equity market; it matters more than anything else. A ratings downgrade is an issue, but it’s an issue the market anticipates and will deal with. That’s not the driver. The driver is what’s going to happen to the economy.

As to the creditworthiness of U.S. debt, whether you rate it AAA or AA, Treasures “are still the safest investment on the planet,” said David Rosenberg, chief economist and strategist at Gluskin Sheff in Toronto.

When you consider that the U.S. economy has a total net worth of at least $80 trillion, the largest GDP and the biggest army, it’s hard to believe in an Armageddon scenario.

The notion that the U.S. would default “is totally preposterous,” Rosenberg said. “This is not about the U.S. ability to service its debt. This is pure politics.” As Reuters reported last week, the Obama administration has grown frustrated with Standard & Poor’s, accusing the ratings agency of changing the goalposts in its downgrade warnings.

Unlike a mere ratings cut that might be taken in stride, however, an outright default — still seen as very unlikely — could have devastating consequences for the global economy.

What would more likely ensue if the debt ceiling does not get raised is a big, sudden dose of fiscal restraint — bitter medicine that could poison a frail economic recovery. Adds Rosenberg:

We will see first-hand what it means to balance the budget and from an economic standpoint, it ain’t gonna be a pretty picture. Bondholders will be made good. Social Security, Medicare, and veterans’ benefits will be paid. But everything else will fall by the wayside.

A fall in “discretionary” government spending to zero would lead to “a very deep recession,” he said. Then, whether it’s rated AAA or AA+, “you will find a lot of people buying Treasuries because that’s what people will want to own when we go to a negative growth rate.”

 

 

 

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It’s really too bad because it would be so easy to correct our overspending problem.

We could close some the least strategically important military bases that we maintain around the world and shy away from being the world’s cop on the beat.

We could also make cuts in Medicare and Medicaid by commissioning a panel of medical experts and medical ethicists to come up with a rating system that rations out certain procedures.

For example, my father developed lung cancer from decades of smoking. Though his doctor told him that his cancer was terminal still had expensive chemo, even though his doctor told him in advance that there was very little chance that it would buy him much time. My father didn’t even want to go through the misery of it, but my mother couldn’t bear the thought of not trying something. He also had a procedure done in which an adhesive solution was placed between his rib cage and lung in an effort to keep a lung from collapsing.

He died a few months later as his doctor predicted, but not until after the taxpayers paid for those ridiculous procedures.

They were unnecessary expenses and they caused a lot of unnecessary suffering. Even though my mother was not a medical professional and she was ill-equipped to make sound medical decisions, she was still able to control what should have been medical decisions.

I work in the medical field and I have seen many similar situations; this is not an unusual kind of event.

As our population ages, families who wish to spend their own assets in situations similar to this should be permitted to do so, but they should not be permitted to fund futile, expensive efforts with public money.

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