Yesterday, credit rating agency Standard & Poors revised its credit rating outlook on U.S. sovereign debt to “stable” from “negative.”
In 2011, S&P was the first of the three major rating agencies to strip the U.S. of its AAA rating (currently, it has the U.S. at AA+).
BofA Merrill Lynch interest rate strategist Priya Misra warns clients in a note that the other two major raters, Moody’s and Fitch, will probably also strip the U.S. of its AAA rating sometime this year – and, believe it or not, the downgrades could actually catch the market by surprise.
We continue to believe that Moody’s and Fitch are more likely than not to downgrade the US one notch this year, which would put them in line with S&P. Based upon their reports and our own analysis, to maintain AAA status, Moody’s and Fitch would need to see approximately US$1tn in additional deficit reductions over the decade – on top of the existing full sequester – to produce medium-term stabilisation, followed by a decline in the US debt/GDP ratio.
CBO’s GDP estimates are likely optimistic relative to rating agency assumptions. Even if Moody’s and Fitch agree with CBO’s deficits, a 4% nominal GDP growth assumption beyond 2013 would result in debt-to-GDP declining to 73.2% before rising again.
To the extent that US downgrade risks are still at play for the market, the removal of S&P from the rating story is a positive for Treasury rates, relative to swaps and spread products in general. But we do not think the market is fully pricing in a Moodys/Fitch single-notch downgrade this year. While the surprise factor of a Moody’s move this summer would be quite mild relative to the S&P downgrade in August 2011, we think it could catch the market off guard, given the recent improvements on the deficit front. We believe a downgrade would result in a steeper 5s-30s curve, tightening of swap spreads and a marginal underperformance of Treasuries with respect to corporates and MBS.
Yesterday, the S&P announcement did seem to have a marginal impact on markets, at least in the morning.
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