Lost AAA Brings Falling Yields-to-Deficits on DowngradeJohn Detrixhe and Matt Robinson
Ever since Standard & Poor’s stripped the U.S. of its AAA credit rating almost two years ago, the unemployment rate has fallen, household wealth has reached a record and the budget deficit is shrinking. More downgrades may be coming, anyway.
While S&P boosted its outlook for the U.S.’s AA+ grade earlier this week to “stable” from “negative,” Moody’s Investors Service said it’s awaiting lawmakers’ budget decisions this year as it weighs reducing America’s Aaa. Fitch Ratings, which has a “negative” outlook on the U.S., said in February that the debt trajectory isn’t consistent with a AAA borrower.
Yields on Treasuries are lower, the dollar is stronger and the S&P 500 Index of stocks reached a record high since Aug. 5, 2011, when S&P said the U.S. was less creditworthy than Luxembourg and 17 other sovereigns. The Congressional Budget Office said the federal deficit this fiscal year will be the smallest since 2008, while the economy is forecast to grow next year at the fastest pace since 2006. Even S&P said it sees “tentative improvements” as debt-to-gross-domestic-product stabilizes.
Investors will “just laugh at you if you downgraded today,” said Vincent Truglia, who was managing director in charge of Canada at Moody’s when the New York-based company restored that nation’s top rating in 2002, in a June 11 telephone interview. “The deficits are falling fast, and they’re not going to be rising for years.”
Attempting to predict the market consequence of a rating change has proven to be little different than flipping a coin. Yields on government securities moved in the opposite direction from what ratings suggested in 53 percent of 32 upgrades, downgrades and changes in credit outlook last year, according to data compiled by Bloomberg on Moody’s and S&P grades.
Bond markets shouldn’t be expected to react when a country’s credit rating is changed because the yield of sovereign debt reflects more than just the credit risk on which rankings hinge, according to Fitch. Richard Cantor, Moody’s chief credit officer, said last year that “we have only one objective, which is to assign ratings that are indicative of the relative risk of default and losses.”
Some investment programs are prevented from owning anything except AAA securities, and ratings changes can boost volatility. S&P’s downgrade contributed to a global stock-market rout that erased about $6 trillion in value between July 26 and Aug. 12, 2011.
The impact was short-lived. Yields on 10-year Treasuries were at 2.13 percent in New York yesterday, below the 2.56 percent when S&P cut the U.S. grade. Intercontinental Exchange Inc.’s U.S. Dollar Index, which measures the greenback against the euro, yen, pound, Swiss franc, Canada dollar and Swedish krona, has risen 8 percent to 80.678. The S&P 500 is up 36 percent to 1,636.36.
“Folks want to react to the latest sound bite, and ratings inherently aren’t about that,” Mark Adelson, who was chief credit officer at S&P when the U.S. rating was cut and current chief strategy officer for BondFactor Co., said in a June 11 telephone interview. “If you do a rating change and everyone is happy and agrees with you, you’re late. You’ve created no value.”
In downgrading the U.S., S&P said political fighting made it less confident Congress would end tax cuts enacted under President George W. Bush or tackle entitlements programs, such as Social Security and Medicaid. Social Security is the federal retirement and disability program, funded primarily by payroll taxes paid by workers and employers. Medicaid provides health-care coverage for poor people, administered by the states and funded jointly by the state and federal governments.
S&P’s decision was flawed by a $2 trillion error, according to the Treasury Department. Moritz Kraemer, S&P’s head of sovereign ratings for Europe, the Middle East and Africa, said in April 2012 that “there was no mistake” and that the discussion hinged on which nonpartisan CBO fiscal scenario baseline to use in the rating company’s credit analysis.
S&P said using the Treasury’s preferred spending measures didn’t affect its decision. A Bloomberg Global Poll in September 2011 found that 67 percent of 1,031 global investors said S&P’s move was justified.
The U.S. is now on stronger footing. The unemployment rate in the U.S. was 7.6 percent in May, down from 9 percent in August 2011, and GDP has grown for 15 straight quarters. The expansion has averaged about 2 percent on an annual basis.
Consumer confidence climbed in May to the highest level in more than five years and home prices advanced to the most since 2006. Net worth for households and non-profit groups has eclipsed its pre-recession level, increasing by $3 trillion from January through March, or 4.5 percent from the previous three months, to $70.3 trillion, the Federal Reserve said June 6.
Increased tax revenue and less spending mean America’s budget deficit will probably drop to about 2.1 percent of GDP in 2015, from 4 percent this year and 7 percent in 2012, according to the CBO.
The government’s priority should be reducing unemployment, not cutting the deficit, according to Paul Krugman, a Princeton University economist and Nobel laureate, who has been critical of austerity in the U.S. and Europe. America’s 7.6 percent unemployment rate compares with an average of 6.8 percent during the past 10 years and a low of 4.4 percent in 2006.
“We do not, repeat do not, face any kind of deficit crisis either now or for years to come,” Krugman wrote in a March 10 article on the New York Times website. “Yes, we’ll want to reduce deficits once the economy recovers, and there are gratifying signs that a solid recovery is finally under way. But unemployment, especially long-term unemployment, is still unacceptably high.”
Moody’s, which placed a “negative” outlook on America’s Aaa credit rating in August 2011, is awaiting the outcome of budget negotiations before making a decision, said Steven Hess, senior vice-president and lead sovereign analyst for the U.S.
A downgrade “is not a done deal,” Hess said June 12 in a telephone interview. “We are observing considerable improvement in the economy, employment and, it’s not that there’s a boom, but things are moving in a positive direction. We would be more comfortable in maintaining the Aaa rating if we could see some improvement in that ratio of debt-to-GDP over the medium term.”
The CBO estimates debt will rise about 1 percentage point in 2014 to 76 percent of GDP even as the budget deficit shrinks this fiscal year to $642 billion, the smallest since 2008 and less than half 2009’s record $1.4 trillion. The latest projections are “credit positive” for the U.S., Moody’s said May 20 in a report.
“Perhaps things have tilted slightly in a positive direction, based on developments in the economy and the fiscal outlook,” Hess said. “The deficits are declining, but the ratio of debt to GDP is still rising.”
Fitch has had a “negative” outlook on the U.S. since November 2011 and plans to resolve the grade by early July, according to Dan Noonan, a spokesman for the firm. Fitch said in a February report that stabilizing the U.S. grade would require “confidence that public debt will be placed on a downward path in the latter half of the decade.”
Fitch’s own projections “could imply some reduction in the path of debt to GDP,” David Riley, Fitch’s lead sovereign analyst, said in an e-mailed statement on June 12.
S&P boosted its rating outlook to “stable” from “negative” on June 10, meaning the U.S. has a less than one-in-three likelihood of a downgrade in the “near term” with the revision, it said.
The company said it sees “tentative improvements,” such as the deal politicians reached to resolve the so-called fiscal cliff of automatic spending cuts and tax increases and through the Budget Control Act of 2011.
“S&P’s downgrade needed to be done because the U.S. had a governance issue, but you can’t make the argument on a purely fiscal basis today,” said Truglia, who is now a consultant for the Bertelsmann Foundation, where he helped develop a proposal for creating a nonprofit rating company. If the economy “keeps growing and all these revenues keep pouring in, and unless there is a shock, there’s nothing that will prevent this recovery.”
Consensus in Washington on spending levels and taxes, especially on big-ticket items such as Social Security and Medicaid, is elusive, raising concern among the ratings companies.
President Barack Obama sent a $3.8 trillion budget to Congress in April calling for more tax revenue and slower growth in Social Security benefits. The House passed a plan that balances the budget by fiscal 2023 without raising taxes.
“Entitlement spending and tax reform is just not going to be realized, plain and simple,” Adrian Miller, the head of fixed-income strategy at GMP Securities LLC in New York, said June 10 in a phone interview. “As long as you can have growth at a pace that drops the deficit, from the market’s perspective, that’s all they’re looking for since that’s how you really judge the credit worthiness of a sovereign.”
The Internal Revenue Service’s review of Tea Party groups and the Justice Department’s seizure of Associated Press telephone records are emboldening Republicans to take a harder stance against Democrat proposals, said Steven Bell, the chief of staff for the Senate Budget Committee from 1981 through 1986.
“Republicans feel that the only thing they got as far as smaller government for spending was the Budget Control Act of 2011,” Bell, a senior director of economic policy at the Bipartisan Policy Center in Washington, said in a June 11 telephone interview. “The president cannot deliver, even if he wished to, the majority of the Democratic caucuses on a bill that would fundamentally change the debt trajectory.”
The Budget Control Act of 2011 raised the debt limit in exchange for the creation of a government panel tasked with finding deficit reduction of at least $1.2 trillion. The so-called supercommittee failed to reach an agreement, triggering across-the-board cuts of the same amount that began this year.
While the CBO sees U.S. debt falling to less than 71 percent of GDP by fiscal 2018, the ratio will then rise, “pointing to the uncertain long-term outlook if reform of entitlement programs does not take place at some point,” Moody’s said in the May 20 report.
Fitch said in February it will eventually reach 110 percent when including local government and state debt, a level “not consistent” with a top ranking.
U.S. downgrades by Moody’s and Fitch are the “base case” for Bank of America Merrill Lynch, according to Priya Misra, head of U.S. rates strategy in New York. The firm is one of the 21 primary dealers of U.S. government securities that are obligated to bid at Treasury auctions.
“Chance of further deficit reduction from the policy front is miniscule,” Misra said June 11 in a telephone interview. “It should result” in limited market reaction “because S&P already has us at that level, and everyone is thinking growth is in a better situation,” she said.
The government’s failure to reach a deal on entitlements and longer-term spending in 2013, the first year of Obama’s second term, would be “a missed opportunity,” said Peter Hooper, the New York-based chief economist at Deutsche Bank Securities Inc., a primary dealer.
“It’s sort of a wake-up call to say, ’well, you don’t really deserve this Aaa rating because you don’t have a system that works effectively and you’re complacent about your level of debt,’” Hooper said in a telephone interview June 11 in reference to a potential Moody’s downgrade. “Because it’s such a mixed picture on the fiscal front, because we’ve had what appears to be better news, people are going to be puzzled about this.”