Another US downgrade might not be as bad as it sounds

On August 8, 2011, the first trading day after Standard & Poor’s downgraded the US credit rating for the first time ever, the S&P 500 stock index plunged by 6.5%. There was no quick recovery. Stocks continued to slide and didn’t regain prior highs until six months later.

Fitch Ratings said on May 24 it could downgrade the US credit rating if the current standoff over raising the US borrowing limit results in any missed federal payments, which could happen within a week or two. That would be the second downgrade of the US credit rating. Yet markets shook off the news, with the S&P (^GSPC) rising modestly after the Fitch announcement.

Why the difference? A few reasons. First, the novelty is gone — the second time isn’t usually as shocking as the first. Another reason is the Fitch warning may actually help create some urgency for Congress to make a deal and raise the borrowing limit. Finally, investors know that the 2011 credit downgrade didn’t raise US borrowing costs or roil the market for US Treasuries, as many initially feared. In fact, interest rates on US debt fell after the 2011 downgrade, lowering US borrowing costs in a paradoxical market reaction to political dysfunction that in theory should have brought punishment, not reward.

In its May 24 warning, Fitch placed the United States on “credit watch negative,” meaning it could downgrade US debt from its top AAA rating if Congress doesn’t resolve the current impasse in time to prevent missed payments. The agency said it does expect Congress to raise the borrowing limit before there’s any kind of default. But it did highlight a deteriorating debt outlook along with political paralysis as risks to the nation’s creditworthiness.

“Governance is a weakness,” Fitch said, “and the future direction of the rating is sensitive to the direction it takes. The contested 2020 presidential election, brinkmanship over the debt limit to advance political agendas, and failure to reach consensus on the country's fiscal challenges are recent signs of the deterioration in governance.”

S&P sounded similar alarms when it downgraded the US credit rating from AAA to AA+ 12 years ago. Since then, the nation’s indebtedness has grown substantially worse. The national debt has exploded from about $15 trillion in 2011 to more than $31 trillion today. As a percentage of GDP, total federal debt has ballooned from 65% in 2011 to 95%. The Congressional Budget Office forecasts that will rise to 132% ten years from now.

Credit downgrades normally raise the cost of borrowing, because investors view the debt being downgraded as riskier and demand a higher interest rate as a result. But the United States is uniquely privileged, given that Treasuries represent the world’s largest bond market, and the dollar is the world’s reserve currency.

In 2011, after the S&P downgrade, interest rates on Treasuries actually fell, because investors worried about financial turmoil flocked to the safest assets they could find — US Treasuries. Rising demand pushes interest rates down since the issuer can offer a lower return and still find buyers. That's what happened in 2011, as more people suddenly wanted to buy Treasuries. On the day after the S&P downgrade, the 10-year Treasury rate was 2.58%. Three trading days later it had dropped to 2.17%. The 10-year ended 2011 at 1.89%, defying the normal rules about what happens to debt when perceived risk goes up.

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There were a few factors at play in 2011, including a debt crisis in Europe, that contributed to investor flight into US Treasuries. That’s not an issue now, but forecasters still think there could be a similar surge in demand for Treasuries if Congress muffs the borrowing limit and there’s some kind of default. “Even without the additional supportive factors, we would expect a significant flight-to-safety if the parties fail to reach an agreement this year,” Oxford Economics advised in a May 23 analysis.

While a downgrade by Fitch or any rating agency wouldn’t be ruinous, it wouldn't be painless, either. Moody’s, which also rates US credit as AAA, pointed out in a May 4 report that a downgrade of US debt could cause financial stress at a range of entities linked to the US government, such as mortgage agencies Fannie Mae and Freddie Mac, and private-sector companies heavily exposed to federal spending. The worst effects would come if a downgrade occurred because of an actual default on a bill, rather than a downgrade in principle that was not accompanied by an outright default.

There’s an important distinction between downgrade and default. The worst kind of default would be the failure to pay interest on a US Treasury security, which by definition would trigger a downgrade, probably by every agency that rates US debt. That would be a first-of-its-kind event likely to roil financial markets. That’s also unlikely to happen. The Treasury Dept. would probably suspend every other type of payment before it suspended interest payments, meaning it might never have to take that drastic step.

If the United States had to suspend or delay payments to vendors or federal employees or recipients of transfer payments, such as Social Security enrollees, that would be serious, but not as serious as failing to make interest payments. That, too, would be unprecedented, but it’s not clear whether it would trigger a downgrade.

S&P issued its downgrade in 2011 without the United States missing any payments. In its latest analysis, S&P said it could lower the US credit rating “if unexpected negative political developments weigh on the strength of American institutions.” Without spelling it out, that sounds as if it would take some kind of non-payment to force another S&P downgrade.

Even without a fresh downgrade, there’s already stress in the market for short-term Treasuries. Datatrek recently pointed out that every T-bill with a maturity of six months or less now yields more than the federal funds rate, which suggests investors are demanding a premium for purchasing debt that could be subject to default in the next several months, while negotiators work on a debt-ceiling deal.

Those rates could fall back to par with the federal funds rate if there's a deal, and the current crisis disappears. But the Great American Debt Pileup is only going to become more precarious, as Washington borrows increasingly more and some spending programs become untenable. A mere warning of a credit downgrade may one day be a fond and distant memory.

Rick Newman is a senior columnist for Yahoo Finance. Follow him on Twitter at @rickjnewman

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