What’s an A between friends


What difference does it make whether US Treasury debt is AAA rated or AA?  The greatest danger is that a downgrade damages consumer and business confidence in the US.  Recall that in the Lehman Brothers collapse of late 2008 the biggest problem ultimately was that consumer and business confidence fell off a cliff after 15 September 2008.  US consumer confidence went to the lowest levels since accurate records began in the 1950s.  The resultant fall in consumer spending and business investment turned a financial crisis pre-Lehman into the Great Recession post Lehman.  That is the biggest problem with this debt crisis — it could trash consumer confidence in the US and elsewhere and send the fragile recovery in the US into full reverse.

Most households have got no idea what the issues are in the US debt crisis or a sense of the scale of the problem.  When it is reported that gross debt of the US Government is now about 100% of GDP or that the budget deficit is $1.25 trillion this year, it is hard for most people to interpret those figures, so the problem seems somehow distant to them and just so much more noise from Washington.  But a downgrade from AAA to AA sounds so dramatic.  It is a statement that the US Government is no longer gold plate, no longer bullet proof.  It shakes the rock on which confidence rests — faith in the permanence and destiny of the Republic.

If consumer and business confidence was not at risk, then a downgrade would not be such a big deal.  So, Moody’s and S&P have lowered their opinion of the credit worthiness of the US Government — big deal.  Plenty of pundits are telling us that it does matter, without explaining why.  For instance, this morning on the ABC’s AM radio program we were told that if the US loses its AAA rating then interest payments on US debt will rise by up to $100 billion per year.  Let’s think about that.  $100 billion on $14 trillion of debt is about 0.7% (70 bps).  The contention here is that if the US is downgraded then the USD yield curve will jump up by 70 bps.  That seems completely implausible.

Why would the yields (interest rates) on US Treasury securities rise at all if the US was downgraded?  After all, those ratings are just the opinions of the ratings agencies.  If we were talking about some corporation or bank that the market doesn’t pay much attention to, then a downgrade would certainly change the market’s thinking on that corporation and shift the yield on that debt upwards.  But we are talking about the US Government here.  The markets do not rely on the ratings agencies to form an opinion about the credit worthiness of the US Government.

It is supply and demand for US treasury securities that determines the yield on US Government debt, not the adding or subtracting of a single ‘A’.  The supply of Treasuries expands only slowly through time.  So, a big jump in yields would require a big fall in demand for US treasuries.  Why would that happen?  It is quite possible that the opposite would happen.  If the debt stand-off in the US causes a global financial panic, then the flight to quality will be into US treasuries sending demand for those securities up and their yields down.  That is not just a theoretical possibility — that is the mostly likely outcome if financial crisis arises.  No matter what Moody’s and S&P think, US Government debt will remain the risk free asset for $US investors.

Putting aside crisis considerations, what else might cause a drop in demand for US treasuries?  First, there are capital adequacy issues.  Banks, insurance firms and others have to hold an amount of shareholder capital that reflects the risk that they have absorbed onto their balance sheets.  Some banks may have to hold more capital against their US debt holdings; making the holding of US treasuries more expensive and therefore inclining them to sell the securities.  However, most banks won’t be affected because US treasury debt will continue to have a risk weighting of zero, even if it is not AAA.  Capital adequacy rules for insurance companies are different and some insurance companies will partially sell down their US treasury holdings.

Second, there will be an issue with the use of US treasuries as collateral.  Treasuries are used as collateral in the repo market, in the risk markets (options, futures, etc.) and elsewhere.  For instance, if a bank was short of cash for a day it might uses some of its holding of treasury assets to borrow overnight cash in the repo market.  In this transaction $1.00 of Treasuries can be used as collateral on borrowing of $0.99 of cash.  We would say that the ‘haircut’ on the collateral is 1%.  If US debt is downgraded then the haircut applied to treasuries might rise to 2% or more, in which case $1.00 of Treasuries will only support $0.98 of borrowing.  That would reduce the size of positions that can be taken in the repo market and in the risk markets, and other markets.  If many parties are forced to unwind positions simultaneously by selling assets, then a ‘fire sale’ of assets can arise.

It is hard to know how big these effects are.  In some ways this ensuing crisis has the feel of Y2K about it.  We don’t know whether the passing of August 2 and a US rating downgrade be a bang or a whimper?  I think it will be a bang — not because of the effects on financial markets, but because of the effect on US consumer confidence.

16 Responses to "What’s an A between friends"
  1. Even iff the effect is only marginal due to the scale of US T bills and their effective use as currency the results would be dramatic. If it were to kick up borrowing cost by only .07bps then that’s an extra $10billion, half nasa’s budget

  2. I think it would be a “non-event”, just as it was for Japan’s downgrade.  It will be another example that critics of rating agencies will point to.  Just my call. I am curious to see if US treasury debt will still be regarded as “risk-free” by the market.  If so, one good outcome might be that governments with higher rated debt (such as Australia’s) will be less worried about being downgraded to the level of US treasury debt.

  3. The downgrade will make a difference because a bunch of money-market funds etc. will have to dump US bonds if their investment policy allocates a certain amount to AAA securities. The biggest impact will be if social security etc. payments are stopped to do an instant budget balance. I think the Republicans won’t be able though to hold off signing up to anything that Obama wants in that situation.

  4. “It is supply and demand for US treasury securities that determines the yield on US Government debt”

    If that is the case then how come yields are at 0% when supply is close to $14 trillion? Also when supply was much lower (say early 80s) yields we much higher. 

  5. Phil 
    The yield is anchored at the left hand side by the Fed Funds rate.  But that won’t change after Aug 2.  The low yields on Treasuries (30 year bonds are yielding 4.50%) is because of high demand.  The Fed only sets the Fed Funds rate.  Otherwise it is all supply and demand.  How else do you think Treasury prices are formed?

  6. The loan rate is just an expectation of the future fed funds rate. 

    There is always demand for bonds because deficit spending provides the private sector with the net financial assets required to purchase government debt.

  7. The fed can also control the long rate not just the short rate. This has been contemplated with QE3 (targeting yield not just maturity).

    In short, the government bond market is very far from a normal market governed by the rules of supply and demand.  

  8. “The low yields on Treasuries (30 year bonds are yielding 4.50%) is because of high demand.”

    One last point… I would say the 4.5% yield on 30yr bonds is low relative to history but very high relative to Japan!


  9. Phil It might seem like the Fed or the US Treasury can change the shape of the yield curve, but there is no empirical evidence of that.  The US Treasury in the Kennedy administration issues short term debt to buy long term debt, but it had no long run effect.

  10. There is no demand and supply curve for US debt.

    When the US government deficit spends, they credit  the bank accounts of individuals electronically.  This creates a “net financial asset” in the non Government sector.

    The issue of bonds simply drains the non government sector of cash reserves (created by by the deficit).  So the supply of government securities will always = demand.  

    So in that sense, Phil is right.  The long bond rate is entirely determined by the expected Fed Funds rate. 

    Whether this debt ceiling bill is passed or not, treasury yields will fall.  This is because either way the US is running head-on into a world of austerity.  We know what that has done to parts of Europe (Irish GDP down 20%). So the Fed funds rate will be near zero for a very very very long time.  30 Year UST’s will eventually fall to 2% IMO.

  11. I said they can choose to control the long term debt rate – that doesn’t mean they have ever chosen to.

    So yes, I agree, we don’t have empirical evidence, but that doesn’t invalidate my point. 

  12. “The US Treasury in the Kennedy administration issues short term debt to buy long term debt, but it had no long run effect.”

    That was a completely different monetary system.  The US closed the Gold window in 1971.  It has been a pure FIAT monetary system ever since. 

    Phil is right.  The Fed controls the price of overnight money using OMO.  It can do that anywhere along the curve if it so chooses.

    In fact, the Fed can acquire all $14T of US Government bonds for cash, and eliminate the entire bond market.   

  13. Phil and MMT 
    You guys have got the wrong idea about how the yield curve is created.  It is anchored at the left hand end by the Fed.  The longer the maturity the less that anchoring matters.  Supply and demand for treasuries sets the yield.  Simple as that.  Do you think the Fed targets rates along the yield curve?  The point at hand is whether a ratings downgrade will shift the yield curve — apparently not because in your world the Fed sets the yield curve. 

  14. Sam,

    Please re read my post. The fed does not set the yield curve, but can if they so desire.

    Not sure wat a downgrade could do in the short term, but over the longer term yields are going down. Ratings agencies have zero cred, and it is clear they do not understand the monetary system.

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