When Standard & Poor’s downgraded the U.S. government’s credit rating in August, predictions of serious fallout soon followed.
Republican presidential candidate Mitt Romney described it as a “meltdown” reminiscent of the economic crises of Jimmy Carter’s presidency. He warned of higher long-term interest rates and damage to foreign investors’ confidence in the U.S.
U.S. House Budget Committee Chairman Paul Ryan said the government’s loss of its AAA rating would raise the cost of mortgages and car loans. Mohamed El-Erian, chief executive officer of Pacific Investment Management Co., said over time the standing of the dollar and U.S. financial markets would erode and credit costs rise “for virtually all American borrowers.”
They were wrong. Almost a year later, mortgage rates have dropped to record lows, the government’s borrowing costs have eased, the dollar and the benchmark S&P stock index are up, and global investors’ enthusiasm for Treasury debt has strengthened.
“The U.S. Treasury is still the widest, deepest and most actively traded in the world,” said Jeffrey Caughron, a partner at Baker Group LP in Oklahoma City, which advises community banks on investments of more than $40 billion. “That becomes all the more important when you have signs of weakening global economic growth and continued problems in Europe.”
Even in a slow recovery, the U.S. has unparalleled assets in the global market, including the size and resilience of its economy and the dollar’s standing as the world’s reserve currency. Low Treasury yields show that most investors think the U.S. government will meet its obligations, no matter how dysfunctional the political climate becomes in Washington.
Warren Buffett, the Omaha, Nebraska-based billionaire investor, turned out to be prescient in shrugging off the downgrade: “In Omaha, the U.S. is still triple-A,” Buffett said in 2011 amid the uproar. “In fact, if there were a quadruple-A rating, I’d give the U.S. that.”
Still, there is broad agreement that the U.S. must address the long-term fiscal imbalances that have driven public debt up to 68 percent of gross domestic product. Ryan and other pessimists contend the country is benefiting from temporary forces such as a flight of capital from Europe’s sovereign debt crisis and the Federal Reserve’s “Operation Twist” program to buy long-term debt.
They warn that the window financial markets have provided could close at some unpredictable time if the budget issues aren’t resolved. Standing in the way of a resolution is a widening partisan divide in Washington.
Standard & Poor’s lowered the U.S. credit rating after months of wrangling last year between President Barack Obama and congressional Republicans over whether to raise the federal debt limit. Though the impasse ended with Obama signing a debt-ceiling increase on Aug. 2, S&P downgraded the U.S three days later, citing political gridlock in Washington and the nation’s long-term fiscal challenges.
Treasuries responded by staging the biggest rally since December 2008, returning 2.8 percent that month as investors repudiated the decision.
Yields on Treasuries due in 10 years have fallen 1.07 percentage point since the downgrade and have touched all-time lows, dropping to 1.44 percent on June 1. U.S. government bond prices, which move in inverse proportion to yields, have soared, such that the securities have gained 7 percent since Aug. 5 after returning 9.8 percent in 2011, their best performance since 2008, Bank of America Merrill Lynch index data show.
As a result, the naysayers would have earned about $8.59 million on a $100 million investment in Treasuries maturing in five to 10 years had they started a trade the day the U.S. was downgraded, according to the Merrill Lynch index data. Hedge funds worldwide have lost about 5.8 percent during that span, which would amount to a $5.8 million loss on a $100 million investment through the end of June, according to the Bloomberg Global Aggregate Hedge fund index.
Almost half the time, yields on government bonds fall when a rating action by S&P and Moody’s suggests they should climb, according to data compiled by Bloomberg on 314 upgrades, downgrades and outlook changes going back as far as the 1970s.
The rally showed the downgrade “was a mistake,” Alan Blinder, a Princeton University professor and former Federal Reserve Board vice chairman, said in a July 2 interview in New York. “The U.S. Treasury is still at the top of the heap.”
Consumer borrowing costs have also dropped. Home loan rates for 30-year U.S. mortgages on July 12 fell to a record low for a fourth straight week. The average rate for a 30-year fixed mortgage declined to 3.56 percent in the week ended July 12, the lowest in Freddie Mac records dating to 1971. In the week ended Aug. 4, 2011, immediately before the downgrade, the average rate was 4.39 percent.
IntercontinentalExchange Inc.’s Dollar Index, which tracks the greenback against the currencies of six major U.S. trading partners, has climbed about 12 percent since S&P’s Aug. 5 downgrade, as of July 13. The S&P 500 stock index has returned 15.6 percent, including reinvested dividends.
The U.S. attraction for global investors has strengthened. In May, 46 percent of international investors chose the U.S. as the market with the most potential during the next year, up from 31 percent a year earlier, according to a Bloomberg poll.
Because the consequences that had been forecast for a downgrade haven’t occurred, lawmakers may become more entrenched in their positions in the next standoff over fiscal policy, approaching at the end of the year. The threat of a downgrade has lost some of its power, said Steve Bell, a former Republican staff director for the Senate Budget Committee.
“You cried wolf, and no wolf appeared,” said Bell, who’s now a senior director at the Bipartisan Policy Center in Washington. “It has persuaded a fair number of members of Congress that the effect of a downgrade is overstated and it will not lead to some serious economic or financial problem.”
Still, the possibility of another downgrade will weigh on policy makers, said William Daley, Obama’s former White House chief of staff. Even though Treasury yields fell, “consumer confidence dropped dramatically after the downgrade, and do we really want to test that again?” he said.
The Conference Board’s Consumer Confidence index plunged from 59.2 in July 2011 to 45.2 in August in the wake of the debt standoff and credit downgrade. The index didn’t recover to its July level until December.
Growth in consumer spending slowed from 0.8 percent in July of last year to 0.1 percent in August before rebounding to 0.7 percent in September.
Investors in America
Romney, speaking to reporters in Concord, New Hampshire, three days after the downgrade, said the ratings cut “has a consequence not only for our borrowing cost long-term, but also for the ability of America to have the confidence of people around the world as investors in America.”
Glenn Hubbard, a Romney economic adviser, said in a July 12 telephone interview that the Republican candidate “was and is absolutely right.” Flight of capital out of Europe, a slowing world economy and the Fed’s program of replacing holdings of short-term debt with longer-term securities have obscured the impact of the downgrade, he said.
Ryan, a Wisconsin Republican, also defended his warning, saying interest rates haven’t gone up only because so many other nations are in such bad shape.
“We are a safe haven for now” for investors because of Europe’s debt crisis, Ryan said in an interview. Rates will rise, he predicted. “We just don’t know when, and I don’t want to tempt fate.”
El-Erian of Newport Beach, California-based Pimco, which oversees the world’s biggest bond fund, didn’t respond to a request for comment.
Terry Belton, global head of fixed-income and foreign-exchange research at JPMorgan Chase & Co. in New York, said on a July 26, 2011, conference call that a downgrade could boost Treasury yields by as much as 70 basis points in the intermediate term and increase the government’s borrowing costs by $100 billion a year. A basis point is 0.01 percentage point.
Instead, the U.S. is on track to pay less interest this year. U.S. Treasury securities paid $454 billion of interest last year, according to the Congressional Budget Office. That’s projected to decline to $442 billion this year and won’t climb above the 2011 cost level until 2015, according to CBO forecasts.
Weakening U.S. credit quality, such that the nation more resembles a AA rated borrower, is still likely to drive up 10-year yields by about 60 basis points over time, JPMorgan’s Belton said in a recent interview.
“Yield changes during the last year had nothing to do with the downgrade, but it had to do with everything else pushing yields lower,” Belton said. “On the top of that list you have a massive flight to quality out of Europe, and the U.S. is a safe haven.”
Investors outside the U.S. owned $5.16 trillion of U.S. government debt as of April 30, compared with $4.7 trillion at the end of July 2011 before the credit-rating cut.
“The one thing the Treasury market has above any other government bond market is liquidity,” Stuart Thomson, a money manager in Glasgow at Ignis Asset Management, which oversees the equivalent of $109 billion, said in a June 22 interview. “That liquidity premium is not going to disappear no matter how many downgrades Moody’s or S&P give to it.”
Bidders offered $3.16 for each dollar of the $1.075 trillion of notes and bonds auctioned by the Treasury Department this year as of July 2, as yields reached all-time lows, above the previous high of $3.04 in all of 2011, according to data compiled by Bloomberg. The so-called bid-to-cover ratio was 2.26 from 1998 to 2001 when the nation ran budget surpluses.
Thanks to Europe
“The Europeans have been making us look great,” said Phillip Swagel, former assistant Treasury secretary for economic policy in the George W. Bush administration and now a professor at the University of Maryland in College Park. “It’s all relative. We don’t have the political will to solve our problems that aren’t far over the horizon, but the Europeans don’t have the political will to solve the problems at their doorstep.”
S&P said last month that political and fiscal risks could lead to a second downgrade of U.S. debt by 2014. While Moody’s and Fitch Ratings have kept their top grades on the U.S., both have a negative outlook.
Nobel laureate Paul Krugman said before the downgrade that an S&P cut would be “no big deal,” according to an April 18, 2011, New York Times blog post.
“They have no really solid grip on what it is that they’re talking about,” Krugman, an economics professor at Princeton University, said in a telephone interview on May 9 of this year. “What does it mean to give the U.S. a credit rating? It’s unlikely the U.S. will ever default, we might engage in some inflation. So what is it that they’re talking about?”