After the wrangling over raising the US federal debt ceiling and talk of the US government potentially defaulting on some of its debt, the focus is shifting on the possible downgrading of the US federal debt rating from its current AAA status.
When Standard & Poors placed the US debt rating on negative CreditWatch in July, the rating agency explained the move with the potential default as well as the little likelihood that Congress and the administration would agree on credible, medium-term fiscal consolidation plan.
“We may lower the long-term rating on the US by one or more notches into the ‘AA’ category in the next three months, if we conclude that Congress and the Obama administration have not achieved a credible solution to the rising US government debt burden and are not likely to achieve one in the foreseeable future,” Standard & Poors said on 18 July.
The credit rating agency believes that the US debt trajectory will continue to increase, if Washington produces a medium-term fiscal consolidation plan of less than $4 trillion for the next 10 to 12 years.
The proposed spending cuts of $2.4 trillion over a decade may not be enough to convince the rating agencies that the necessary actions have been taken. In particular the inability to politically agree and implement a debt consolidation plan in a timely manner is inconsistent with a triple-A sovereign rating, S&P said. The current agreement calls for just under $1 trillion in initial cuts. A joint committee of Congress will have to find another $1.5 trillion, leaving ample room for uncertainty over whether the cuts can be achieved.
Swiss bank Credit Suisse in a report noted a 50 per cent chance that S&P and Moody’s will cut the US credit rating, but doubted that such a move would have much of an effect, referring to Japan’s debt which has been assigned a double-A rating and still yields a low 1.1 per cent.
This may, however, downplay the actual effect a deteriorating credit rating may have. JP Morgan’s Head of Fixed Income Terry Belton points out that a double-A rating will mean significantly higher borrowing costs for the US government of about $100 billion in annual interest payments alone. The effect would also not be limited to sovereign debt, because the government lending rate is used as a floor for other lending rates, such as mortgages, student loans, personal loans and corporate debt. JP Morgan estimates this could add 0.6 to 0.7 percentage points to borrowing rates.
This in turn will negatively impact economic sentiment in the US. According to a Reuters poll, 38 out of 54 surveyed economists said the uncertainty following from Washington’s indecisiveness in finding a solution to the debt problem had already hurt economic growth. A majority of economists also stated it is likely that the US debt will be downgraded even after the deal between Congress and the president has been struck.
At the same time a cut in the US credit rating might hit stock prices, further exacerbating confidence in the economy.
The pressure that higher borrowing costs will put on both the US economy and the US dollar will also impact Cayman, given the strong ties between the two economies and the peg of Cayman’s currency to the US dollar.
Meanwhile a downgrading of the rating would impact other triple-A rated issuers that are directly linked to the US government’s rating, such as AAA-rated bonds issued by banks and other organisations guaranteed by the US government, including Fannie Mae and Freddie Mac, certain municipal bonds and structured securities that use securities from any of these issuers as collateral.
The credit risk of other AAA-rated US companies, financial institutions, municipal issuers and structured finance vehicles might also rise in the event of a US rating downgrade “due to the implied macroeconomic, banking system and foreign exchange risk”, Moody’s said in a statement.
However, for most issuers the link would be relatively weak so that they could withstand a downgrade of the US debt rating by one or two notches, the rating agency conceded. US states and local governments, however, would be more susceptible to a downgrading, which would drive up their borrowing costs.
S&P does not expect a significant market disruption after a ratings downgrade, after the raising of the debt ceiling and a default has been avoided. Yet the rating agency still predicts that it will take rating actions, including outlook revisions, on specific companies with businesses, operating earnings and assets that are largely US based and specifically those that rely on US government contracts.
The ratings of financial institutions could be affected depending on the sensitivity of their funding profiles to US Treasuries and the severity of short-term interest rate movements, S&P indicated.
Despite the increase in borrowing costs for US Treasuries as a result of a downgrading, the securities are unlikely to lose attractiveness among international investors, simply because the liquidity of alternatives, for example triple-A rated Swiss or German treasuries, is not large enough.