Confused About Credibility?

Talk of credit ratings agencies swirled again Wednesday—some tied to the ongoing (and seemingly neverending) US debt ceiling debate and some unrelated to it—likely contributing to some stock market volatility.

Many opine that even if (or more likely, when) the debt ceiling is raised, the all-clear won’t be sounded because ratings agencies may still offer their (frequently wrong) opinion on US creditworthiness. They claim the raters need to see a debt ceiling increase and a “credible plan” for reducing deficits or America’s AAA credit rating may be lowered.

But it seems to us ratings agencies are a bit more confused than usual lately. Wednesday, both Moody’s Global Managing Director Michael Rowan and S&P President Deven Sharma said their companies won’t analyze political “plans or policies” until they become law. Which raises a salient question: What exactly, then, was their criteria for putting the US on negative credit watch? Elevated deficits were a known quantity long before S&P and Moody’s changed their outlook—and both principally cited the debt ceiling debate as their motivation. Also consider Moody’s previously said the US credit rating would not be at less risk of downgrade if the debt ceiling were eliminated. This seemingly indicates a “credible plan” isn’t part of their criteria whatsoever—and that they’re perfectly willing to discuss potential policy measures not even being discussed in Congress, much less signed into law. We’re not going to speculate about what credit ratings agencies might do—after all, we’re not in their brains and they’re certainly entitled to their opinions. In our view, it’s far more important to recall there’s nothing magic or catastrophic about changes in their opinions.

In November 1998, Moody’s elected to cut Japan from the slim global depth chart of Aaa rated sovereigns—downgrading their rating to Aa1. So what happened? Did rates spike higher and remain elevated? Actually, no. Long-term rates incrementally rose for a few months after the announcement, but reversed back to previous levels in fairly short order, as continuing economic growth alleviated concern over Japan’s debt-servicing capability. Similarly, equity markets experienced short-lived volatility, with a rapid recovery. Take note: No major credit calamity ensued. They did it again in 2002. Rates fell.

As for the US presently, one thing many overlook is there aren’t many AAA (or Aaa, as it were) rated sovereign issuers. So as we note here, there’s likely insufficient supply of attractive AAA rated government debt to meet full investor demand—meaning a mass Treasury exodus is highly unlikely because there are few alternatives.

And one can see this in US debt markets. Wednesday—while all the shouting and grumbling continued over ratings, debt ceilings, default fears, deficit plans, political bickering, blame games, gridlock and more—the US government held an auction of five-year Treasurys. If there were really much investor concern over all these topics, one should rationally expect higher bond yields and slack demand. But that isn’t what happened. At auction, the government offered $35,000,022,200 in notes. Investors bid for $91,844,358,700—a bid-to-cover ratio of 2.62, showing healthy demand. As for rates, they fell versus five-year note auctions in June. And May. And April. And March. And February. And January. You read that right—rates at Wednesday’s five-year note auction were the lowest all year—even though we’ve hit the debt ceiling and the Treasury’s stated deadline is about a week away.

Overall, folks seem to misunderstand what drives demand for US debt—assuming Treasurys are attractive just because they’re AAA. But in reality, Treasurys are attractive because of the depth of our capital markets, liquidity, use of the dollar in trade, our legal and economic systems’ strengths, our ability to service the debt and much more. In other words, it’s not just our AAA status. Focusing solely on a label issued by credit ratings agencies with lackluster historical track records is quite misleading.

Ultimately, what needs a “credible plan” most is reform of the ratings agencies. Too bad that’s truly lacking.