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Realistically, nobody knows exactly what impact the S&P downgrade of US sovereign credit from AAA to AA+ means.But it’d be boring and foolish not to guess.
Here’s a snip from a note from Barclays’ Ajay Rajadhyaksha.
First, the near-term implications:
Investor sentiment is clearly fragile after the drop in all risky assets over the last several days. But the near-term impacts of this one-notch downgrade should be minimal for the US bond markets, in part because sentiment is so fragile.
- We do not anticipate forced selling of US Treasuries from any significant investor base. Foreign central banks maintain a large share of their FX reserves in USTs because it is the deepest and most liquid bond market. This is unlikely to change due to a ratings downgrade. Mutual fund investment guidelines retain significant flexibility regarding the handling of this action. The US banking system should not be forced to sell as well because the Fed has issued a guideline noting no change in risk weights. Similarly, insurance companies are also unlikely to be forced to sell as the NAIC has already de-emphasised ratings for regulatory capital requirements.
- Haircuts in the repo market may rise but since haircuts or margins are meant to protect cash lenders from daily price fluctuations in the collateral, they are more likely to depend on changes in price volatility of Treasuries, rather than just a downgrade in itself.
- Similarly, in the derivatives market, most CSAs do not explicitly draw a link between the eligibility of US Treasuries as collateral and their AAA rating. In addition, given that major US banks are several notches below AAA, a single-notch downgrade should not lead to downgrades in the credit ratings of banks. Even if that were to occur, additional collateral requirements would be manageable in our view.
And then some long-term implications:
Being the world’s reserve currency seems incongruous with a AA rating. The longer-term effects are driven primarily by whether markets eventually also downgrade the US. In that case, the biggest impact should be through the effect on the USD as a reserve currency.
- Based on prior research, we believe that a one-notch downgrade would lead to an increase of 25bp in borrowing costs. But this is not a function of a specific rating action, but of the market downgrading the sovereign rating.
- A downgrade could increase diversification away from the USD. Foreign investors have supplied 30-40% of non-financial credit creation in the US over the past few years. An increase in the pace of diversification should be an economic drag, as domestic savings would have to rise to pick up the slack