Tags: US | Debt | Showdown | Rating

US Could Still Lose AAA Rating Despite Deal

Monday, 01 Aug 2011 07:10 PM

 

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Even if Congress approves a deal to raise the federal government's debt ceiling, the U.S. could still lose its coveted AAA debt rating sometime in the next six months, largely because the proposed agreement does not cut enough spending.

The three main ratings agencies declined to comment Monday on the prospect of future downgrades. But the agencies, along with economists and analysts, have signaled that doubts about the nation's debt will persist.

Moody's Investors Services has said it will probably rate the U.S. debt as AAA for now but with a negative outlook — a rating that indicates a possible downgrade yet to come.

Fitch Ratings has indicated the deficit must be reduced to a "more sustainable level" for the U.S. to maintain its AAA rating. And Standard & Poor's has said any deal to raise the debt ceiling must cut at least $4 trillion from future budget deficits or the rating will probably be lowered to AA.

The proposal crafted by Obama and congressional leaders cuts only about half that amount, which led at least one expert to suggest that S&P could still downgrade the rating as early as next month.

"The details (of the deal) don't look as pretty as the headlines," said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott.

Ratings agencies probably won't look favorably on the fact that most of the spending cuts in the current plan won't be made until after 2013, LeBas said.

"That means you're waiting longer to do the saving, and you would have accumulated more debt," LeBas said. And if the deal is passed, but only by a slim margin, it might indicate to the rating agencies that lawmakers "will reverse or water down the measures" in the future. Both could be the catalyst for a downgrade, he said.

Avalon Partners chief economist Peter Cardillo believes there is a 70 percent chance of the U.S. being downgraded to a AA credit rating within the next six months, as more details of the spending cuts emerge.

But both Cardillo and LeBas said a downgrade — once considered highly unlikely and catastrophic — might not be that bad for the U.S.

A credit rating downgrade usually leads to higher interest rates, said Kim Caughey-Forrest, senior stock research analyst at Fort Pitt Capital Group. That would make it more expensive for governments, companies and consumers to borrow money. The 10-year Treasury note is considered the floor for all other interest rates, so higher rates could raise borrowing costs on everything from mortgage loans to credit cards.

But the conventional wisdom that rates will rise sharply on a downgrade might not hold up. A study released last week by JPMorgan Chase bond strategists points to a more gradual increase.

The study showed just a slight increase in lending rates when countries lose their AAA rating. In May 1998, S&P knocked Belgium, Italy and Spain from AAA to AA. A week later, 10-year rates had barely budged. In some cases, rates actually fell. A week after S&P took Ireland's AAA rating away in March 2009, 10-year rates in that country fell 0.18 percentage points.

Analysts and bond traders are not convinced rates will rise much if the U.S. loses its AAA rating. Caughey-Forrest and others note the recent high demand — and the resulting falling yield — for Treasurys.

Global investors still consider U.S. debt one of the safest investments. Many mutual funds, money market funds and banks find U.S. debt so safe they hold Treasurys as a proxy for cash. And they've continued to do so, despite the threat of a debt default and a downgrade.

The yield on the 10-year Treasury note was at or below 3 percent in July and dropped to 2.75 percent on Monday, an eight-month low.

A downgrade could spur a "quick jolt of nervous, knee-jerk selling" of bonds, LeBas said. Some money-market funds could be forced to sell U.S. government debt if they require client money to be invested in only AAA-rated debt. The combination would likely cause yields on Treasurys to rise in the short term, said Brad Hintz of Bernstein Research.

LeBas expects yields on 10-year Treasurys to jump above 3.5 percent this year — not a level traders consider to be a significant increase. When the recession began in December 2007, yields were as high as 4.20 percent.

But Hintz, LeBas and others said demand for Treasurys will return quickly, sending yields back down.

"A downgrade won't frighten foreign buyers away because this is the largest market and there's no other place to go," Cardillo said.

Treasurys have a solid appeal for the world's central banks. China's central bank holds an estimated $1.16 trillion. Japan, the second largest foreign owner, holds $912 billion.

And at $9.3 trillion, the U.S. government bond market is massive compared to other countries. Treasurys are also considered the easiest security to buy and sell quickly. Daily trading of Treasurys runs at $580 billion, far higher than British gilts ($34 billion) or German bunds ($28 billion), according to a recent study by Fitch.

"I think no matter what happens, Treasurys are the safe haven," said Dan Greenhaus, chief global strategist at the brokerage BTIG in New York. "No other market is as large or as liquid."

© Copyright 2014 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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