The real danger from the downgrade of U.S. government debt by Standard & Poor’s isn’t higher interest rates. It’s the hit to the nation’s fragile economic psyche and rattled financial markets.
S&P’s decision to strip the U.S. of its sterling AAA credit rating for the first time and move it down one notch, to AA+, deals a blow to the confidence of consumers and businesses at a dangerous time, economists say.
The agency is “striking at the heart of what makes the global economy tick,” says Chris Rupkey, chief financial economists for the Bank of Tokyo-Mitsubishi UFJ. “It isn’t just dollars and cents.”
A look at this downgrade, and downgrades in general — and what they mean:
Q: What did Standard & Poor’s do?
A: The ratings agency downgraded its rating on the federal government’s long-term debt one level from the top AAA grade to AA+. Long-term debt includes notes and bonds that come due in more than one year.
They have terms ranging from two to 30 years. Short-term debt includes Treasury bills that have terms ranging from a few days to 52 weeks.
The rating on the government’s short-term debt was not downgraded. Of the $9.4 billion in publicly traded U.S. government debt, 72 percent is long-term.
Q: What does a downgrade mean?
A: A downgrade is a warning to buyers of bonds and other debt that the chance that they won’t get their money back has increased, however slightly. In theory, downgrades should lead to higher borrowing costs for the issuer (in this case, the government), since investors demand a higher interest rate if they’re taking a bigger risk.
Q: Does it mean U.S. interest rates will go up?
A: The 10-year Treasury note is considered the basis for all other interest rates, so higher rates on that and other long-term U.S. debt could lead to borrowing costs on everything from mortgages to car loans. That would also make it more expensive for state and local governments, companies and consumers to borrow money.
But it’s not clear that S&P’s downgrade will have an effect on rates. Treasury securities are a foundation of the U.S. financial system and are still considered one of the safest investments in the world. As stocks plunged the last two weeks, the price of Treasurys soared because demand was high, even though investors knew there might be a downgrade. Since yields on debt securities fall as prices rise, the yield on the 10-year note dropped from 2.96 percent on July 22 to 2.39 percent on Friday.
A downgrade could spur a “quick jolt of nervous, knee-jerk selling” of bonds, raising rates in the short term, said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott. But investors are so worried about the economy and need the safety of Treasurys that they could quickly become buyers again.
Q: Wasn’t this what the debt limit agreement in Congress was supposed to prevent?
A: Yes, but S&P sees the agreement as falling short of what’s necessary to fix the nation’s finances. The spending cuts Democrats and Republicans agreed on were relatively modest. More difficult, comprehensive cuts were pushed to the future. S&P also notes that the possibility of new revenue, for instance from tax increases, appears more remote than before. The rancor around the agreement also made it more clear how far apart Democrats and Republicans are. “Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden,” S&P said.
Q: What did the other ratings agencies do?
A: The two other major agencies haven’t taken action yet. Moody’s Investor Service has said it might downgrade the U.S. rating, but its chief economist noted Friday that Treasury securities “are still the gold standard.” Fitch Ratings said last week that the agreement on budget cuts was an important first step but “not the end of the process.”
Q: How many times has the U.S. been downgraded below AAA?
A: Never. The S&P has given the U.S. a AAA rating since 1941. The U.S. and has only faced the threat of a downgrade once. In 1995, when Bill Clinton was president, a similar default loomed and the credit rating agencies warned of a downgrade. At the time, the country had $4.9 trillion in debt — nearly $10 trillion less than now. Once Congress resolved that debt crisis a year later, the credit agencies removed their warning.
Q: How has a downgrade affected other countries?
A: In May 1998, S&P knocked Belgium, Italy and Spain from AAA to AA. A week later, their 10-year rates had barely budged. In some cases, fell. A week after S&P took Ireland’s AAA rating away in March 2009, 10-year rates in that country had fallen 0.18 percentage points.
Q: What other countries have AAA ratings from S&P?
A: Britain, Germany, Australia, Austria, Denmark, the Netherlands, Norway and Finland are among those that have the top rating.
Q: How big is the market for U.S. government bonds?
A: At $9.3 trillion, the U.S. government bond market is massive compared with those of other countries. Daily trading of Treasurys runs at $580 billion, far higher than British gilts ($34 billion) or German bunds ($28 billion), according to a recent study by Fitch.
“I think no matter what happens, Treasurys are the safe haven,” said Dan Greenhaus, chief global strategist at the brokerage BTIG in New York. “No other market is as large or as liquid.”
Treasurys have a solid appeal for the world’s central banks. China’s central bank holds an estimated $1.16 trillion. Japan, the second largest foreign owner, holds $912 billion.
Fitch said the status of the U.S. dollar and the size of the Treasury market are the biggest reasons investors won’t abandon Treasurys soon. The dollar is the global reserve currency, which means a significant amount of global purchases are made in dollars — like toys and computer chips from China, coffee from Kenya, cars from Japan and oil from all over the world. Central banks in other countries therefore hold large reserves of U.S. currency, mostly through Treasury purchases.
Q: How long might it take for the U.S. to regain a AAA rating?
A: Analysts say it could be tough for the U.S. to regain the AAA rating soon especially given its current economic challenges. S&P officials implied that it will take years to see a meaningful change in the U.S. fiscal situation and in the government’s ability to cut the budget.