The USA Gets Downgraded – Almost
By Mark Oelschlager, CFA
Portfolio Manager
April 21, 2011
This week one of the major ratings agencies, Standard and Poor, lowered the outlook for United States Treasury debt from stable to negative. To clarify, this technically is not a ratings downgrade – the US maintains its AAA rating – but the reduced outlook is a warning and can lead to a downgrade. The reason S&P took this action is simple: the agency is concerned about the large federal budget deficit, mounting debt, and the inability of the government, so far, to do anything about it. The last point is key. If S&P sensed a resolve to rectify the problem, it likely would not have changed the rating. But, noting the wide gap between Democrats and Republicans on the issue, it expressed concern about an agreement being consummated. Hence the reduction in outlook.
Interestingly, when this was announced, stocks sold off, but bonds were relatively flat. Treasury bonds are typically a beneficiary of a flight to safety, but when the trigger is concern about those very bonds, investors aren’t sure how to react! Another explanation for the lack of reaction from the bond market is that S&P was merely announcing formally what the market had already discounted (that being a deteriorating fiscal situation). Ratings agencies are notoriously late in adjusting their corporate bond ratings.
S&P started adding these “outlooks” to its ratings in 1989. This is the first time the US has not been labeled “stable” (and its rating has always been AAA). S&P says that, with this change, the chance of a ratings downgrade is 1 in 3, but history says the odds are 56%, which is the percentage of nations that had a reduced outlook and then went on to be downgraded (The Wall Street Journal).
Both political parties are trying to use this as leverage to achieve their goals. The fact that this is being viewed as a political opportunity might indicate that at least some in Washington still don’t appreciate the seriousness of the issue. There has always been talk in Washington about the deficit problem, and it has always worked itself out – that might be part of their thinking. They also might not appreciate the consequences of not addressing the problem; when all one has known is the US Dollar as the world’s reserve currency and the US as the world’s economic superpower, it is difficult to imagine things differently. Politicians also tend not to take difficult action until there is a crisis. As serious as the fiscal situation is, it has not yet reached the point at which something must be done immediately (as in “right now”). This explains why Congress has yet to seriously address the problem, attacking spending around the edges rather than at the core (Social Security, Medicare and Medicaid).
Why would a downgrade of US Treasury debt matter? Investors would demand a higher rate of interest on their money, which of course would increase the interest cost to the US Treasury of financing the $14 trillion in debt outstanding. One thing that has actually been working in our favor is that interest rates have been low, which keeps interest payments (an outlay, just like any other budget item) low. If rates were to increase, the cost of servicing the debt would increase as well, which would just exacerbate the problem. The thing about debt, whether one is talking about a company, person, or nation, is that it can snowball. The time at which the borrower is being charged the most is the time the borrower can least afford to be charged a high rate. A higher interest rate makes a deficit problem more difficult to deal with, which makes borrowing that much more difficult, and so on.
One of the most under-reported stories in recent years is the failure of the US government to lock in low borrowing rates to finance its mountain of debt. With the yield curve normally upward sloping (long-term rates higher than short-term rates), the US has done most of its borrowing at the short end of the curve (a couple years or less). This results in lower borrowing costs in the short term, but introduces rollover risk. When that short-term debt matures, and the US needs to issue new debt to continue to operate, if rates have increased then interest payments will have increased as well. Last summer, ten-year Treasury bonds were yielding 2.5%, which meant that the Treasury could have locked in its borrowing costs at 2.5% for ten years. Instead of taking advantage of this, they continued to issue debt on the short end of the curve where rates were lower. Even today, with the ten-year at 3.40%, it would be prudent to borrow more at longer maturities. But they have not done this, which means that if rates rise to 5%, 6% or higher, borrowing costs will jump, adding to the deficit and debt.
All of this sounds ominous, but there are reasons for hope. There has been a clear shift in Washington, with the debt and deficit now the prominent issue. The electorate is concerned, and many of the politicians seem to be as well. There does seem to be a desire to solve the problem. It is a question of whether they will make the tough political choices necessary to fundamentally change things. One possibility is that, year after year, Washington does just enough to keep the problem at bay, so that it never really goes away.
Another reason to temper concern is the case of Japan. The US has one of the highest debt/GDP ratios in the world at 92%. Japan’s is 220%, and it has had low interest rates for many years. Of course, this could also be explained in part by the anemic economic growth in Japan, but the point is that there is a precedent of low interest rates and ballooning debt.
The US Dollar’s status as the world’s unofficial reserve currency is an important thing we have going for us. Countries like China, India, and Japan have an economic interest in the US remaining strong, so that 1) we can continue to buy their exports and 2) their large holdings of US debt retain their value.
But Washington is going to have to take the necessary steps to slow the growth in outlays. Investment strategist Dr. Ed Yardeni of Yardeni Research, Inc. likes to say that the cure for high commodity prices is high commodity prices, meaning that high commodity prices lead to consequences and actions that lead to lower prices. Perhaps one could make a similar assessment about the US fiscal situation. The cure for a ballooning debt problem is a ballooning debt problem.
We at Oak have always spent a lot of time analyzing the macro picture, and we will of course monitor this situation and adjust our portfolios accordingly.
Best regards,
Mark Oelschlager, CFA
Portfolio Manager
Oak Associates Funds
This manager commentary represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice.
Investments are subject to market fluctuations and a fund’s share price can fall because of weakness in the broad market, a particular industry, or a specific holding.
Definition(s):
AAA – A bond rating provided by rating agency Standard & Poor’s. AAA is Standard & Poor’s highest bond rating and reflects a high likelihood that borrower will repay debts.