The asset class generally seen as the least risky in the world – US Treasuries – just got a bit riskier.
On Friday night our time, credit rating agency S&P did what its peers Moody’s and Fitch didn’t dare to do. It downgraded the US.
Not by much, of course. The country’s credit rating was shifted down a notch, from the perfect AAA, to the very slightly less perfect AA+.
But it does mean that US government debt – generally viewed by the market to be the ultimate in risk-free assets – now has an official question mark hanging over it.
So what does this mean for you?
The S&P downgrade is all about politics
Why did S&P downgrade the US? It’s all about politics. The agency’s basic argument is that the US political system is currently too dysfunctional to make the decisions needed to get the country back on a sustainable path.
The reaction was predictable, if depressing. The government slated S&P, saying its calculations on the US national debt were out by $2 trillion. But don’t be fooled. We’re talking about the difference between one very big number – $22 trillion – and another very big number – $20 trillion – over the course of ten years. As Terry Smith of Tullett Prebon pointed out on Radio 4’s Today programme on Saturday, neither estimate will turn out to be right in the end anyway. The important thing is that the debt is continuing to rise at an unsustainable rate.
S&P’s fundamental point stands: the faffing about over the debt ceiling showed that the way things stand, it’s no sure thing that the US will find a way out of this mess without a lot more pain.
But what does it all mean for investors?
From a practical point of view, it should mean very little for US Treasuries themselves. We wouldn’t invest in US Treasuries, but we didn’t like them this time last week either.
By the same token, if you were willing to lend to the US government on Friday morning, nothing has happened to change your mind now. The state of US politics, or the nation’s balance sheet, didn’t suddenly get worse when S&P downgraded it.
As Lex puts it in the FT, the downgrade “is merely a trailing indicator of a situation of which investors in the world’s most analysed economy are already well aware.”
So talk that US borrowing costs will now rise as a direct result of this is really just lazy commentary. Indeed, costs could conceivably fall if investors panic about the other potential knock-on effects, and rush to US Treasuries in fear of more stock market turmoil.
The danger lies in the shadow banking system
What are the potential knock-on effects? Regulators have made it clear that this won’t affect the amount of capital that banks have to hold against holdings of US debt, or debt guaranteed by the US (such as mortgage-backed bonds). So there won’t be any forced selling on that score.
What is more worrying is the impact on the ‘shadow banking system’. US Treasuries are often used as security by institutions to borrow money. The risk is that lenders will now demand bigger ‘haircuts’ when Treasuries are used. In other words, those using Treasuries as security won’t be able to borrow quite as much money against them.
It could also have an impact on derivatives contracts, “many of which were written on the assumption that the US government was rated triple A,” notes the FT.
It’s hard to be sure of the exact consequences, as many deals are done between two parties, so there’s no ‘standard’ contract as such. Thomas Stoddard of Blackstone Group tells Reuters: “Not having the US as triple-A is just going to pop up in more places and have more frictional costs than people might suspect.”
The bottom line is that this has the potential to make financing more expensive, and less widely available. The cost of borrowing for the US government might not go up. But the cost of borrowing for anyone using US Treasuries as collateral could rise despite that.
Tighter credit conditions would only increase the chance that we suffer a fresh recession sooner rather than later. Take a look at the current issue of MoneyWeek magazine to find out why James Ferguson thinks the US could be back in recession this time next year. If you’re not already a subscriber, subscribe to MoneyWeek magazine.
What does this mean for your portfolio?
A downgrade to the US is of course, what fans of gold have been predicting for years, often to ridicule. With gold now above $1,700 an ounce, they don’t look quite as unhinged now.
Obviously we’re still keen on gold, although it’s worth remembering that if the market turmoil worsens, gold could well suffer. It’s a very liquid asset and just as happened in 2008, it may end up being sold to fund ‘margin calls’ on less liquid assets. But that sort of fall would be temporary.
As for stocks, stay defensive. If investors do start worrying about the quality of government debt, then high-yielding blue chips with plenty of cash will start looking attractive as possible alternatives.
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