Debt Downgrade Amounts to Few Basis Points in Rating History
As the prospect for the loss of the U.S.’s AAA credit rating approaches and congressional leaders agree on a pact to avert default, bonds and currencies are signaling increasing demand for the assets of the world’s largest economy.
Treasury yields average 0.72 percentage point less than the rest of the world’s sovereign debt markets, Bank of America Merrill Lynch indexes show. The difference has expanded from 0.15 percentage point in January. The dollar saw greater than average net inflows last week compared with the previous year, according to Bank of New York Mellon, the custodian for more than $20 trillion.
Investors from China to the U.K. are lending money to the U.S. government for a decade at the lowest rates of the year. For many of them, there are few alternatives outside the U.S., no matter what its credit rating. President Barack Obama said leaders of both parties in the U.S. House and Senate approved an agreement to raise the nation’s debt ceiling and cut the federal deficit, in a televised speech yesterday in Washington.
“There is no other country that can step in and replace the U.S. at the core of the system,” Mohamed El-Erian, the chief executive officer at Newport Beach, California-based Pacific Investment Management Co., which manages the world’s largest bond fund, said July 25 in an interview on Bloomberg Television. “The U.S. is the supplier of the reserve currency.”
The dollar represents 60.7 percent of the world’s currency reserves, compared with the 26.6 percent for the euro, which has the next biggest portion, according to the International Monetary Fund in Washington.
Ten-year Treasury yields fell 17 basis points, or 0.17 percentage point, last week to 2.80 percent, the lowest level since November. The benchmark 3.125 percent note due May 2021 rose 1 13/32, or $14.06 per $1,000 face amount, to 102 25/32, Bloomberg Bond Trader prices show. The yield fell to as low as 2.72 percent today in New York, the least since November.
The rate is below the 4.05 percent average over the past decade and compares with the average of 5.48 percent when the U.S. was running a budget surplus from 1998 through 2001.
History shows the rate may not rise much, at least not initially. Ten-year yields for the nine sovereign borrowers that have lost their AAA ratings since 1998 rose an average of two basis points in the following week, according to JPMorgan Chase & Co.
“The Treasuries market is the core asset of the financial world and there are very few alternatives for others to go into,” Nick Bennenbroek, the head of currency strategy at Wells Fargo & Co. in New York, said in an interview last week.
In auctions of two-, five- and seven-year notes last week totaling $99 billion, indirect bidders, a class of investors that includes foreign central banks, bought 35 percent of the bonds, up from 30 percent in the June sales.
Congressional leaders are sifting through the details of a tentative bipartisan agreement to raise the debt ceiling, a step needed to allow the government to keep paying its bills, preparing to sell the deal to fellow Republicans and Democrats ahead of possible votes today.
The framework would increase the $14.3 trillion borrowing limit through 2012, cut spending by about $1 trillion and call for enactment of a law shaving another $1.5 trillion from long- term debt by 2021 -- or institute reductions across all government areas, including Medicare and defense programs, according to congressional officials.
Standard & Poor’s indicated last week that anything less than $4 trillion in cuts would jeopardize the U.S.’s AAA rating.
“A grand bargain of that nature would signal the seriousness of policy makers to address the fiscal situation in the U.S.,” John Chambers, chairman of S&P’s sovereign rating committee, said in a video interview distributed by the New York-based ratings firm on July 28.
Moody’s Investors Service reiterated on July 29 that the U.S. should be able to keep its Aaa rating as long as the Treasury agrees to raise the debt ceiling.
Low government debt yields may reflect concern about the health of the economy and the drag spending cuts would have on gross domestic product.
Reductions are “going to be good for Treasuries, ironically, because it’s bad for the economy,” Tad Rivelle, the head of fixed-income investment at Los Angeles-based TCW Group Inc., which manages about $115 billion, said in an interview last week. “It ought to further restrain economic growth by in effect withdrawing a good deal of fiscal stimulus.”
GDP climbed at a 1.3 percent annual rate last quarter, following a 0.4 percent gain in the first quarter that was less than previously estimated, Commerce Department figures showed July 29 in Washington. The median forecast of economists surveyed by Bloomberg News was for a 1.8 percent increase.
The impasse in Congress threatens to turn sentiment against the U.S., according to Mike Schumacher, the head of global interest-rate strategy at UBS AG in New York.
“If there is really a blow-off event in Washington, so let’s say all the discussions completely fall apart over the next few days, you could possibly see the 10-year yield go up to 3.25 percent or 3.3 percent,” Schumacher said in a July 27 radio interview on “Bloomberg Surveillance” with Tom Keene.
Data from the Commodity Futures Trading Commission in Washington show net bets against the dollar rose to 310,222 contracts as of July 26 from 272,444 a week before.
Currency traders speculate the dollar may come under pressure as slower growth keeps the Federal Reserve from raising interest rates from a record low, damping the appeal of U.S. financial assets. Economists at Barclays Capital said in a July 29 report that they now expect the Fed to keep its target rate for overnight loans between banks in a range of zero to 0.25 percent through 2012.
With a spending contraction coming “these are perfect conditions for the Fed to stay on hold for the foreseeable future,” said Shyam Rajan, an interest-rate strategist at Bank of America Merrill Lynch in New York, one of the 20 primary dealers that trade with the Fed. “You’re never going to get the Fed to raise rates” with the economy growing below the long- term trend of 3 percent, he said in an interview last week.
Signs of Strength
There are signs of strength in the U.S. currency. The greenback closed at the end of last month at $1.4399 per euro, up from the three-week low of $1.4578 on July 4.
IntercontinentalExchange Inc.’s Dollar Index, which measures the currency against six of the U.S.’s major trading partners, was at 73.897 on July 29, rising from the low this year of 72.696 on May 4. It rose to 74.144 today.
“Foreign reserve managers have been wrestling with whether they should hold so much in dollar assets for the last several years,” Carl Lantz, the head of interest-rate strategy in New York at Credit Suisse Group AG, a primary dealer, said in an interview last week. “It’s hard to imagine that anything is lower risk than Treasuries, whatever S&P says. We’re an economic and military superpower, we are the reserve currency. It’s still as close as you get to a risk-free asset.”
A downgrade would likely add to the difficulties facing the economy, Obama said in a prime-time speech July 25. A rating reduction would trigger a jump in interest rates on credit cards, mortgages and consumer loans, “which amount to a huge tax hike on the American people,” Obama said.
Mortgage, Corporate Rates
The average rate for a 30-year fixed-rate mortgage rose for a second week, to 4.55 percent, according to Freddie Mac, which compiles data from 125 lenders.
Corporate bonds of all ratings returned an average of 2.04 percent in July, the best since gaining 2.35 percent in the same month last year, Bank of America Merrill Lynch indexes show.
The difference between two-year swap rates and the comparable-maturity Treasury note yield, known as the swap spread, which can signal shortages of liquidity in the financial system, has ranged from 0.15 percentage point to 0.31 percentage point this year. That’s below the 1.65 percentage point gap after Lehman collapsed, and less than the 0.47 percentage point level in June 2010.
“The U.S., downgrade or no downgrade, is still going to be the benchmark,” said Rick Rieder, the chief investment officer at New York-based BlackRock Inc., who manages $612.5 billion in fundamental fixed-income portfolios. “Even with a downgrade, I think the market would assume the safest asset you could buy in a portfolio was still Treasuries.”
To contact the editor responsible for this story: Dave Liedtka at email@example.com