Do Sovereign Downgrades Matter?
Speculation continues to build that another major credit rating agency will downgrade the US this year. What impact, if any, would further sovereign downgrades have on the capital markets?
Larry Swedroe wrote an interesting article last week for CBS MoneyWatch.com on the possible impact on stock markets that a much-rumored potential downgrade of theUS by another major credit rating agency would have. We recently researched the possible impact on bond markets by studying previous downgrades of sovereign debt.
As explained more fully in When ‘Risk-Free’ Isn’t Risk Free: The Impact of a Treasury Downgrade by my colleague Ivan Rudolph-Shabinsky, we found that over the past two decades, yield spreads have typically changed very modestly when highly rated countries are downgraded. In fact, for countries downgraded a single notch to AA+ from AAA, the average spread barely changed at all in the months after the downgrade, as shown at the left side of the Display.
Put simply, a downgrade from AAA to AA or even to A usually doesn’t rattle investors enough to make them question a government’s commitment to meeting its obligations. Markets mostly shrugged off the downgrades of Canada in 1994 and 1995; New Zealand, Finland, Italy, Belgium and Ireland in 1998; and Japan in 2000, 2001, 2002 and 2009.
Unsurprisingly, our research also found that the lower the new rating, the greater the market reaction. Downgrades into the BBB category or lower (the cusp of investment grade) generally led to significantly higher financing costs.
Furthermore, as recent events in Europe suggest, when downgrades take place in the context of a broader economic or financial crisis, yields can rise significantly. This has been seen time and time again, from Italy’s 1991 downgrade in the midst of recession to Iceland’s in 2006, and from Spain and Ireland’s downgrades in 2009 to Spain’s next downgrade in 2010. In each of these cases, the downgrades compounded concerns that were already curbing market appetite for the bonds.
Of course, the situation in Europe today differs in one key respect from many prior instances of sovereign downgrades in developed countries. Euro-area countries today are issuing debt in euros, which is technically more akin to a foreign than a domestic currency. These countries do not have their own central banks and, therefore, do not have the ability to simply print money in their local currency in order to pay back debt.
So, let’s go back to our original question. What would the impact on Treasury yields be if the US were downgraded from AAA to AA+? Our analysis suggests it would be limited, especially given the US’s long-standing status as a safe haven in times of crisis. That status is unlikely to change anytime soon, as I argued in a recent post.
To be sure, given the sheer size and presence of the US market, a sovereign downgrade could provoke a bout of risk aversion across the capital markets, pushing up yields on risk assets globally. But if the market perceives that the US government’s willingness to pay its claims is unchanged, the new bout of risk aversion could even spark safe-haven flows into US Treasuries, supporting prices and lowering yields. In fact, Treasury yields crashed to record lows in 2011, despite the actual downgrade by S&P last summer and threats of additional downgrades.
Of course, European countries like Spain, Ireland and Italy do not have the luxury afforded by safe-haven status. They are under severe pressure to get their fiscal houses in order. But even in the US, government inaction could lead markets to doubt policymakers’ ability to address long-term budgetary issues. In that case, expectations that the only way out of the debt burden is for policymakers to stimulate inflation—perhaps by printing money—could begin to drive up yields. (Inflation is a possible solution because it is much easier to repay debt incurred over many years with less-valuable dollars.) In this scenario, the US could fall into the category of sovereign downgrades that accelerate an already-worsening fiscal situation.
The rating agencies are considering downgrading the US because its debt and deficit numbers are troubling. However, judging from the historically low level of US Treasury yields today, we’re a long way from a crisis. Nonetheless, policymakers cannot afford to be complacent.
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Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income at AllianceBernstein.