A (Non)Default-Fueled Downgrade

The threat of another downgrade likely doesn’t sway investors’ faith in the credit of the US Treasury. Source: Mark Wilson/Getty Images.

In typical fashion, Congress reached a last-minute deal Wednesday to reopen the government and raise the US debt ceiling. For now, anyway—the government is funded through January 15 and the ceiling pushed to February 7. Yep, they kicked the can! So while we may be spared further default jitters, it ain’t all bluebirds and lemonade—especially with ratings agency Fitch mulling a potential US downgrade over (what else!) political squabbles. With plenty more squabbling ahead as Congress approaches its deadline—incidentally, timed to the day the sequester’s next round takes hold—Fitch will have plenty to chew on. We’ll not speculate over its decision—ratings decisions defy logic and aren’t market functions. But if Fitch does knock off an A, it won’t say anything about the US’s creditworthiness, and markets shouldn’t much fuss—they’ve dealt with many an AAA downgrade, and they’ve largely yawned.

Fitch, to its credit (pun intended), wasn’t worried about an actual default. Rather, the rater believes congressional shenanigans shot investors’ confidence in the US government, which could have a downstream impact on borrowing costs. Never mind this debate wasn’t much different from the 107 other debt ceiling spectacles—investors have seen this movie before and know what to expect from Congress. But we wouldn’t expect ratings agencies to take such a pragmatic view.

Especially after Standard and Poor’s downgraded the US in 2011 for the exact same reason—and is still justifying the decision two years later. Then, too, a gridlocked Congress dithered over ... not surprisingly ... the debt ceiling. Politicians eventually compromised, but they took too long for S&P’s liking and went on the naughty list as a result. Folks fretted a downgrade would harm markets and the economy, damage the dollar’s status as the world’s reserve currency, scare foreign investors away and drive up interest rates. But US interest rates fell—the opposite of what you’d expect if creditworthiness were damaged—and they’ve remained historically low ever since.

The US’s experience isn’t unique. In 2012, the UK was downgraded twice (in as many months) after the government delayed its own arbitrary self-imposed deficit targets. Both times, rates fell post-downgrade—suggesting demand for UK gilts wasn’t much swayed. France was downgraded by Moody’s and Standard & Poor’s last year over its competitiveness issues and overall negative outlook. French debt markets largely yawned.

This pattern is fairly typical. Exhibit 1 shows average yields after downgrades from AAA to AA +/-. It’s easy to see debt rates historically haven’t spiraled out of control once a downgrade takes place—rates rise leading into the announcement, but once the uncertainty of whether or not the ratings agency will pull the trigger abates, rates overall fall.

Exhibit 1: Impact of AAA Downgrades

Source: Fisher Investments Research, Thomson Reuters, as of 9/5/2011.^I

While reasons for downgrades may be different, the overall consensus is the same: Ratings agencies’ opinions don’t much matter. They’re notoriously late to the game. They rarely tell investors anything they’re unaware of. Surprises tend to move markets most.

Investors still find the US highly creditworthy—particularly compared to global alternatives. The US still has the deepest, most liquid and, whatever the ratings agencies say, stable political environment relative to investors’ alternatives. Chances that changes because politicians are doing what they do best seem slim to none, in our view. Smart investors recognize political gridlock is normal and the US economy is experiencing healthy, fundamentally supported growth—more than enough to substantiate continued confidence in the full faith and credit of the US.