S&P Downgrades U.S. Debt
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S&P downgraded the US credit rating from AAA to AA+ based on their view that the recent fiscal plan agreed to by Congress and the administration will not stabilize the country's medium-term debt dynamics. The outlook on the long-term rating is negative and S&P could further lower the rating if debt trajectories are higher than currently expected. While the downgrade may lead to higher borrowing costs, its effects are uncertain and the US debt is still considered safe. Secondary impacts through related markets like money market funds and banks' agency debt holdings could be significant.
S&P Downgrades U.S. Debt
- 1. 6363 Woodway Dr Suite 870 Houston, TX 77057 Phone: 713-244-3030 Fax: 713-513-5669 Securities are offered through RAYMOND JAMES FINANCIAL SERVICES, INC. Member FINRA / SIPC Green Financial Group An Independent Firm Weekly Commentary by Dr. Scott Brown S&P Downgrades U.S. Debt August 8, 2011 From S&P Statement: Overview • We have lowered our long-‐term sovereign credit rating on the United States of America to 'AA+' from 'AAA' and affirmed the 'A-‐1+' short-‐term rating. • We have also removed both the short-‐ and long-‐term ratings from CreditWatch negative. • The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-‐term debt dynamics. • More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.
- 2. • Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon. • The outlook on the long-‐term rating is negative. We could lower the long-‐term rating to 'AA' within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case. Outlook The outlook on the long-term rating is negative. As our downside alternate fiscal scenario illustrates, a higher public debt trajectory than we currently assume could lead us to lower the long-term rating again. On the other hand, as our upside scenario highlights, if the recommendations of the Congressional Joint Select Committee on Deficit Reduction -- independently or coupled with other initiatives, such as the lapsing of the 2001 and 2003 tax cuts for high earners -- lead to fiscal consolidation measures beyond the minimum mandated, and we believe they are likely to slow the deterioration of the government's debt dynamics, the long-term rating could stabilize at 'AA+'. On Monday, we will issue separate releases concerning affected ratings in the funds, government- related entities, financial institutions, insurance, public finance, and structured finance sectors. Analysis: S&P’s action is based largely on its view of the political environment. The “short-term” rating was affirmed, meaning that the chance of a U.S. government default within the next 12 months is essentially nil. S&P says its ratings are “primarily determined using a 3-5 year time horizon.” The rhetorical backlash against this move is significant. S&P and other rating agencies did not do a good job ahead of the financial crisis. Most global money managers do their own due diligence, independent of what the rating agencies say, but do react to changing financial market conditions. Nobody knows exactly how the financial markets will react. The first round effects may be limited, but the second and third round effects through related markets may matter a lot more. On one hand, this was only a modest downgrade. Moody’s and Fitch have not lowered their ratings. Some have suggested that S&P’s downgrade will lead to higher borrowing costs. However, U.S. government debt is still considered the “safe” asset. In cases of other downgrades of sovereign debt, long-term interest rates typically did not rise by much. For the U.S., the economic outlook is the more significant driver of bond yields right now. On the other hand, there are many financial entities (such as money market funds) that are required to invest in AAA-rated securities. Money market funds are usually backed by securities with maturities of less than a year, which remain unaffected by S&P’s action, but may include some long-term securities. In recent weeks, money has come out of money market funds and into (FDIC- backed) bank deposits. Those flows may intensify.
- 3. S&P will also downgrade related securities this morning (including agency debt). These second- round effects could be significant. Many commercial banks, for example, have large holdings of Fannie Mae and Freddie Mac debt. These banks may, in turn, move to boost capital and reduce lending to consumers and businesses. Another concern is how this downgrade will combine with already-poor global financial market sentiment. Global stock markets are down and U.S. equity futures are lower. The Federal Reserve is unlikely to initiate a further round of asset purchases in the near term, but could move to shore up money markets and provide liquidity. In issuing guidance to banking organizations for risk-based capital purposes, the Fed indicated that risk weights for Treasuries and agencies will not change. Bottom Line: As it stands, the S&P downgrade of U.S. government debt is the least of our problems. The bigger worry is subpar economic growth and the threat of a new recession.