When “Risk-Free” Is Anything But
July 31, 2011
Rating agencies’ recent threat to downgrade US Treasury debt from its current AAA status has intensified the pressure in the talks to raise the US government’s debt ceiling. Our view is that a deal will eventually be struck between the main US political parties to prevent a default.
Nonetheless, rating agencies have put the US on notice that these issues could lead to a downgrade, regardless of whether the ceiling is raised. What would happen if US Treasury ratings were downgraded?
To find an answer, we looked at sovereign-debt downgrades in some developed economies since 1990. We found that, in most cases where market conditions were generally stable, spreads didn’t widen much either before or after the move.
However, it was a different story when downgrades took place in the context of a broader economic or financial crisis—in those cases, yields rose significantly. These situations included Italy’s 1991 downgrade during the early 1990s recession, Finland’s and Sweden’s downgrade in 1992 after the Soviet banking crisis, and Italy’s downgrade in 1992 during the European Exchange Rate Mechanism crisis. Other examples were Iceland in 2006, Spain and Ireland in 2009, and Spain again last year.
Our analysis suggests there would be only a limited impact on yields if Treasuries were downgraded from AAA to AA, thanks to America’s status as a safe haven and the fact that we are well into an economic rebound. In our view the most likely scenario is that the market will continue to view the US government’s creditworthiness as risk-free—whether the rating agencies act or not.
The bigger question is whether the market will accept that the US is capable of addressing the longer-term imbalances in its budget. The current assumption is that the threat of a crisis will spur the government to act.
But if inflationary expectations take hold and yields start to rise, higher financing costs will start to cause a dramatic deterioration in US fiscal projections. At that point, our analysis would change significantly. The US might see a sovereign downgrade that accelerates an already-worsening fiscal situation. Based on Treasury yield movements, we’re not there yet, but watch this space.