Breaking News
Investing Pro 0
Extended Sale! Save on premium data with Claim 60% OFF

U.S. Credit Rating Downgraded: How Will It Impact Your Investments?

By Alfonso PeccatielloMarket OverviewAug 02, 2023 08:14AM ET
www.investing.com/analysis/us-credit-rating-downgraded-how-will-it-impact-your-investments-200640592
U.S. Credit Rating Downgraded: How Will It Impact Your Investments?
By Alfonso Peccatiello   |  Aug 02, 2023 08:14AM ET
Saved. See Saved Items.
This article has already been saved in your Saved Items
 

Are we back in 2011 or what?

After the US debt ceiling drama earlier this year, we just witnessed a rating agency downgrading the US exactly like in 2011 – back then S&P, this time Fitch.

Today you are likely to read plenty of scary and fear-mongering headlines.

In this piece instead, we’ll take a step back and rationally assess what the US downgrade means for investors and markets out there.

A few words on the reasons behind the downgrade: Fitch pointed out the prolonged discussions on debt ceiling show ‘’deterioration in the standards of governance’’ and the rating agency also sees an economic downturn ahead which is likely to weaken government finances further.

The chart below shows the US spending on interest payments nearing an annualized $1 trillion: a scary chart…if you think the US government has a constrained budget like a household.

But that’s not how it works.

US Fed Govt Interest Payments Surge
US Fed Govt Interest Payments Surge

The government doesn’t ‘’need to find money’’ before delivering deficit spending: the government is the very issuer of the money the private sector uses, so its balance sheet doesn’t work like ours.

Deficit spending creates a hole in the government’s balance sheets and increases our net wealth (it’s nice when they cut your taxes or throw cheques at you, right?) – this increases bank deposits in the system.

More bank deposits (liability for a bank) imply more bank reserves (assets for a bank) in the system too, and when the government issues bonds to ‘’fund’’ its deficit spending, primary dealers can swap these reserves (or use the repo market) for newly auctioned Treasuries.

There are more steps and versions of how this could work, but this stylized example should help you understand the main concept: deficit spending creates money for the private sector, and the government doesn’t ‘’need to find money’’ to spend money – the government creates money in the first place.

US Govt Deficit Spending
US Govt Deficit Spending

Repeating this concept is useful to demystify ‘’scary’’ charts like the one you saw before: yes, government interest payments are rising, but it’s not like the US needs to ‘’choose’’ between spending on interest and spending money in the real economy – its balance sheet doesn’t work like ours.

The real limitation to uncontrolled deficit spending is inflation and scarcity of resources (2021-2022 prime example) and not some budget constraints typical of a household.

How Does Fitch Downgrade Affect Investors and Market Participants?

The key point is that US Treasuries now have their second-best rating at AA+ instead of AAA, given that only Moody’s preserved its top rating for the US.

US Treasuries are the most widely used form of collateral in the world due to their high rating, liquidity, deep repo market, and solid democratic foundations/rule of law: does the downgrade affect that?

Let’s have a quick look at the rating requirements that different institutional players must adhere to when investing in safe government bonds to explore whether a downgrade to AA+ makes a difference.

Commercial banks are huge buyers of Treasuries: they use them as regulatory liquid assets (HQLA), as collateral, and also sometimes as an asset to hedge interest rate risk on their liabilities.

The Basel regulatory framework introduced 10 years ago has 0% capital requirements for government bonds rated between AAA and AA- for its standardized approach: the downgrade to AA+ wouldn’t make any difference.

Most banks actually choose an internal-rating-based (IRB) approach based on internal models, and in that case, most jurisdictions apply an exception for any investment-grade rated domestic government bond, which automatically assigns them a 0% risk weight.

Bottom line: for banks, this downgrade makes no difference at all.

Credit Ratings and Sovereign Risk Weights
Credit Ratings and Sovereign Risk Weights

Pension funds and insurance companies are also large buyers of Treasuries: they use them as a long-duration asset to match their long liabilities (life insurance payouts, pension payouts etc) and as collateral.

For a pension fund, considerations about risk/return profile are important: they not only need to hedge interest rate risk but also try to deliver long-term returns to make the pension system sustainable over time.

AAA-rated or AA+-rated US Treasuries would still fall in the hedging camp or in the defensive asset allocation camp, and a one-notch downgrade wouldn’t make the difference.

When it comes to collateral usage, pension funds, and insurance companies are very active in the repo market: they lend their unsecured cash parked at a bank against collateral to upgrade the safety of their ‘’cash’’ deposits – does a downgrade affect the collateral status of US Treasuries?

These are the recommended haircuts that the Basel committee suggests to apply to collateral lent/received in these transactions:

Securitization Exposure
Securitization Exposure

As you can see, bonds rated between AAA and AA- all fall within the same bucket.

Certain pension funds have stricter collateral demands and only accept AAA collateral, though, but still, the marginal impact of the Fitch downgrade is likely to be extremely minor.

Big buyers of US Treasuries also include FX reserve managers: Chinese or Brazil corporates selling stuff for USD will deposit these US Dollars in the domestic banking system, and so the Bank of Brazil and PBOC would be in charge of investing these USDs in safe, liquid assets – you guessed it: US Treasuries.

Composition of Global Fx Reserves
Composition of Global Fx Reserves

For FX reserve managers, rating considerations are important, but again most countries put AAA-AA rated governments in the same risk bucket.

More importantly, as 70%+ of global transactions are still in USD, there will always be structural demand to recycle these USDs in safe US Treasuries.

What’s the alternative anyway? JGBs with no free float? Europe with a smaller AAA-AA bond market? BRICS with no liquid bond market and democracy/rule of law issues?

As you can see, for most institutional players out there, this downgrade has no material impact that would make them a force-seller of US Treasuries.

But let’s say you want to look at one market indicator that truly signals stress around this – what would it be?

If markets were worried about the collateral quality of US Treasuries, this would be reflected in swap spreads.

Swap spreads are nothing else than the differential between swap rates and Treasury yields: OIS swap yields measure the market-implied return you can make by safely depositing money at the Fed, and hence if Treasury yields rapidly deviate from that it could be because of collateral quality considerations.

There are also other drivers behind swap spreads, but it’s one of the cleanest things to follow here.

In 2011, 5-year swap spreads were very volatile around the downgrade but ended up stabilizing soon after.

Today, we have had no reaction at all so far.

US 5-Yr Swap Spreads
US 5-Yr Swap Spreads

In the short-term, markets can overinterpret and overreact, so it’s important to keep track of sentiment and price action, but in the long run this article covered why this downgrade shouldn’t affect markets much.

U.S. Credit Rating Downgraded: How Will It Impact Your Investments?
 

Related Articles

U.S. Credit Rating Downgraded: How Will It Impact Your Investments?

Add a Comment

Comment Guidelines

We encourage you to use comments to engage with other users, share your perspective and ask questions of authors and each other. However, in order to maintain the high level of discourse we’ve all come to value and expect, please keep the following criteria in mind:  

  •            Enrich the conversation, don’t trash it.

  •           Stay focused and on track. Only post material that’s relevant to the topic being discussed. 

  •           Be respectful. Even negative opinions can be framed positively and diplomatically. Avoid profanity, slander or personal attacks directed at an author or another user. Racism, sexism and other forms of discrimination will not be tolerated.

  • Use standard writing style. Include punctuation and upper and lower cases. Comments that are written in all caps and contain excessive use of symbols will be removed.
  • NOTE: Spam and/or promotional messages and comments containing links will be removed. Phone numbers, email addresses, links to personal or business websites, Skype/Telegram/WhatsApp etc. addresses (including links to groups) will also be removed; self-promotional material or business-related solicitations or PR (ie, contact me for signals/advice etc.), and/or any other comment that contains personal contact specifcs or advertising will be removed as well. In addition, any of the above-mentioned violations may result in suspension of your account.
  • Doxxing. We do not allow any sharing of private or personal contact or other information about any individual or organization. This will result in immediate suspension of the commentor and his or her account.
  • Don’t monopolize the conversation. We appreciate passion and conviction, but we also strongly believe in giving everyone a chance to air their point of view. Therefore, in addition to civil interaction, we expect commenters to offer their opinions succinctly and thoughtfully, but not so repeatedly that others are annoyed or offended. If we receive complaints about individuals who take over a thread or forum, we reserve the right to ban them from the site, without recourse.
  • Only English comments will be allowed.
  • Any comment you publish, together with your investing.com profile, will be public on investing.com and may be indexed and available through third party search engines, such as Google.

Perpetrators of spam or abuse will be deleted from the site and prohibited from future registration at Investing.com’s discretion.

Write your thoughts here
 
Are you sure you want to delete this chart?
 
Post
Post also to:
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Thanks for your comment. Please note that all comments are pending until approved by our moderators. It may therefore take some time before it appears on our website.
Comments (23)
GoTslaGO Tsla
Joetsla Aug 04, 2023 1:06PM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
Printers will work harder…
Jack Lonergan
Jack Lonergan Aug 04, 2023 9:28AM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
Alfonso remains the leader in explaining global macro
Franc Fil
Franc Fil Aug 03, 2023 2:04AM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
The beginning of the end for money printing Fed bureaucrats. Time to cut spending in a massive way.
Michael Byrne
Michael Byrne Aug 02, 2023 6:59PM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
A lot of words to say what Dimon said in two sentences.
Gus McCrae
Gus McCrae Aug 02, 2023 5:33PM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
you forget it's all about trust
David Gentle
David Gentle Aug 02, 2023 5:28PM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
you're a smarty pants Macro Alf
Diego Ponce
Diego Ponce Aug 02, 2023 2:33PM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
What about gold?
Erikke Evans
Erikke Aug 02, 2023 2:33PM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
All assets deflate during a depression.
Erikke Evans
Erikke Aug 02, 2023 1:24PM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
False premise, false principle and false equivalency. Debt creation is not wealth creation. Never has been never will be.
Rich Ash
Rich Ash Aug 02, 2023 12:38PM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
Wonderful article. Problem is my 4 year old does real good stuff with crayons as well
Richie Berg
Richie Berg Aug 02, 2023 12:29PM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
''Today, we have had no reaction at all so far'' So wrong...
 
Are you sure you want to delete this chart?
 
Post
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Add Chart to Comment
Confirm Block

Are you sure you want to block %USER_NAME%?

By doing so, you and %USER_NAME% will not be able to see any of each other's Investing.com's posts.

%USER_NAME% was successfully added to your Block List

Since you’ve just unblocked this person, you must wait 48 hours before renewing the block.

Report this comment

I feel that this comment is:

Comment flagged

Thank You!

Your report has been sent to our moderators for review
Continue with Google
or
Sign up with Email