On Monday, Standard & Poor’s downgraded the U.S.’s credit outlook from stable to negative — while maintaining the U.S.’s AAA rating. This is great news for America and the rest of the world.
By putting a bit of pressure on American policymakers, S&P is reminding us that any country’s credit can and should be analyzed objectively. S&P’s announcement suggests that it should have no problem downgrading countries with problems. The U.S. federal budget deficit is expected to be about 11% of GDP and our national debt is 100% of GDP. Countries with those kinds of numbers are going to get negative views from the ratings agencies.
Ratings agencies have taken a beating when it comes to credibility after pitching in to nearly destroying the global economy during the years preceeding the financial crisis. After all, these agencies competed for billions in fees from investment banks seeking their AAA-imprimatur on bundles of toxic mortgage backed securities. Now those ratings agencies are trying to get the public to forget about that and believe them again.
Of course, nothing in the S&P report is news to investors. Both sides are talking about ways to reduce the U.S. federal deficit by $4 trillion in the next decade and S&P’s report expresses skepticism that a solution can be reached. But this issue has been around for at least two years since the financial crisis started.
And the market reacted wisely to the S&P’s news – by buying U.S. Treasury securities on the assumption that the S&P’s threat to downgrade the U.S. would help solve the problem. How much so? On Monday, the U.S. 10-year treasury bond yield fell to 3.37% from 3.51% last Friday which is lower than Germany’s 3.6% so it looks like the S&P announcement is not spooking investors. In fact, it seems to be having the opposite effect – it is making them more confident about solving the debt problem.
S&P’s announcement helps put pressure on both sides to solve the deficit and debt problem. The drop in the 10 year yield is a signal, as I noted above that investors expect the risk of a U.S. ratings downgrade to boost the odds that a solution will be reached.
Not only that, but the market’s reaction suggests that U.S. policymakers don’t need to concern themselves that the S&P announcement will cause our biggest debt buyers to sell out their positions. In fact, The market’s reaction suggests that Chinese and Japanese investors are going to see U.S. government securities as more attractive because the fear of a downgrade will boost the odds that the U.S. will take affirmative steps to strengthen its financial condition. Thus, the U.S. will reinforce its role as a safe haven.
As a result, S&P’s announcement was a useful nudge to policymakers thinking of using the upcoming negotiations over the national debt ceiling to throw the U.S. into default. S&P has made it clear that it might punish the U.S. if those policymakers fail to come together to solve the budget problem. Even though ratings agencies are in the reputational doghouse, it doesn’t mean that they have no influence at all.
And in this case, S&P’s influence is a good one.