But despite a resolution on the debt-ceiling debate, Standard & Poor’s decided that the deal failed to produce a longer-term solution to the U.S. debt burden. A downgrade from our triple-A credit rating was the result.
The owners of U.S. Treasury's depicted in this chart are what we need to think about when we consider a reaction to a downgrade. The first thing to notice is that the Federal Reserve holds 14 per cent of U.S. government debt. That's one large holder unlikely to sell because of a downgrade.
Money market funds are required to hold highly rated securities. Even so, they are unlikely to be forced to sell in the event of a U.S. rating downgrade.
Regulations allow for the securities held in money market funds to include a broad band of ratings--from triple-A to single-A. The U.S. would have to be downgraded several notches--far beyond what either S&P or Moody's have discussed--before regulations would require money market funds to shun Treasury's.
The most significant group of U.S. bondholders are foreigners, who account for 46 per cent of the country's outstanding government debt.
Foreign U.S. bondholders include sovereign governments and central banks--many of whom are subject to few requirements, if any, when it comes to credit ratings. Traditionally, they invest only in highly rated securities, but as a practical matter they have a lot discretion in what they can hold.
First and foremost on their minds will be the question: Are U.S. government bonds still the safest and most liquid securities on earth?
The answer is likely to be yes--there aren't any practical alternatives.
The EU lacks a unified public security. Germany, partly as a result of its fiscal prudence, lacks the volume. And too many other European sovereign bonds seem riskier than U.S. Treasury's.
Asian debt is an unlikely destination for a flight from U.S. bonds. Chinese government debt is too small and subject to severe capital controls. Its historical experience with debt is also limited.
Japan has enough outstanding debt to be a credible replacement for a portion of foreign holdings of U.S. debt--but Japan's outlook is even worse than that of the U.S.
It seems likely that the German bonds (bunds) would rally, at least on a relative basis to U.S. debt, in the event of a downgrade. Some investors will seek shelter and diversification, and Germany is one of the few nations that can offer a safe alternative to U.S. bonds.
The relative small supply of German debt could create a squeeze, however, if investors push into German bonds.
You might expect that Chinese bonds would follow the same track as German bonds. Don't be so sure.
While its true that some of the same factors apply--apparent safety and lack of supply--China's government is a huge holder of U.S. Treasury's.
If you're afraid of Treasury's, turning to China's debt makes little sense.
It's almost certain that large, too-big-to-fail banks would get downgraded following the downgrade of the U.S. credit rating. These banks currently enjoy higher ratings than they would if not for the perception that they will be bailed out by the government if they get in trouble. If the U.S. debt is riskier, so are the banks backed by the U.S.
If it should happen, this could pose problems for some banks, because it would likely raise their borrowing costs. The most thinly capitalised banks might become distressed.
Some analysts fear that a downgrade of U.S. debt would force banks to raise hundreds of billions in new capital. The analysis works like this:
- Banks aren't required to hold any capital at all against U.S. Treasury's, because the assets are considered risk-free.
- A downgrade would mean these assets are not risk-free, which would mean that banks might have to set aside capital for these assets.
- Banks lack adequate available capital to reserve against their holdings of Treasury's, so they'd have to come to the market to raise new capital.
This outcome is far from certain. It may not even be plausible.
Regulators at the Federal Reserve would likely agree to forebear from requiring banks to hold additional capital against Treasury's--which would eliminate the need for capital increases.
A downgrade of the U.S.'s debt rating could cause a sell-off on the riskiest side of the bond and stock markets. Investors who discover that their portfolios of triple-A rated U.S. Treasury's are now considered technically riskier might decide to rebalance to reduce risk.
The easiest way to do this would be to sell the riskiest portion of your stock and bond portfolio. Since you've lost the safe side of your portfolio, you ditch the risky side.
Perhaps the most surprising result of a downgrade could be a rally in U.S. Treasury's.
Investors selling off riskier assets would need to put the proceeds somewhere, and bonds are likely to benefit. The need to provide more collateral to counter-parties would also increase the demand for Treasures.
The old rule that investors buy Treasuries when seeking liquidity and safety might still apply, creating the very odd effect of U.S. bonds rallying in the face of a downgrade.
The Federal Reserve has a dual mandate: price stability and full employment. Anything that threatens to destabilize markets would likely provoke a response from the Fed.
Some possible responses:
- Making it very clear that the Fed will continue to accept U.S. Treasury's as collateral for every type of transaction, including the discount window.
- Expanding the balance sheet even further and buying bonds from any 'forced sellers.'
- Selling Treasury's if the market responds to a downgrade by rushing into bonds.
- Bank capital relief: As explained earlier, it's likely that banking regulators would not require banks to hold additional capital against Treasury's. After all, they're supposed to be getting rid of ratings requirements altogether.
The U.S. Treasury and the Federal Deposit Insurance Corp. (FDIC) could provide backstops to almost anything they see as irrationally under stress, such as money market funds, bank debt, and insurance company obligations.
The traditional arguments about moral hazard wouldn't apply, since the government likes the kind of moral hazard that encourages people to buy its debt.
S&P downgraded Japan's credit rating in 2002. Many investors figured it would mean that Japanese bond prices would fall and interest-rates would rise. They rose a bit--but far less than the doom-sayers thought.
Betting against Japan's bonds became known as the 'trade of death,' because it doomed so many people.
The most important thing to keep in mind is that there's a technical term for people who tell you that they know with 100 per cent certainty what will happen in the event of a downgrade.
We call them 'liars.'
We're in unprecedented territory, so all we have are educated guesses. Investors need to be cautious, agile and well-informed to protect themselves from unexpected outcomes.
The one thing we know for certain is that there are likely to be surprises ahead.