Two Lower Ratings
When an entity has two out of three ratings in the highest rating category the credit is still considered to have exemplary characteristics. When a change occurs and there are two ratings in the AA category and one rating remains at AAA, some of the luster comes off the credit. In this instance, any change in valuations in the market may be imperceptible but the ongoing consideration remains.
This tautology applies in the case of the new rating status for the USA with the recent Fitch downgrade. It was 2011 when S&P took the action to lower the rating from AAA. In the intervening years, the market for Treasury paper has been as strong as ever. Of course, there are many reasons behind why the market remains strong. The USA continues to possess the reserve currency status for the globe.
Now that Fitch has taken its action on the sovereign rating, it is appropriate to view what has been borne out from the rating action of so long ago.
The one comment that has been spot on is that the outstanding debt not held by the Treasury has increased apace. It was not long ago that we were discussing debt outstanding as a percentage below GDP. On the horizon, we are contemplating the percentage of the debt outstanding to GDP above 100%. According to Fitch, the level of 118.4% is within view for 2025.
The rising interest burden on the budget was also cited as growing to approximately 10% of revenues or well above ratings for peers in the two highest categories. One of the concerns here is the traditional view that there will be a crowding out in store for other spending priorities. There is a good chance that Republican support for defense spending and Democratic support for domestic spending will both be affected. Which party controls congress would be expected to determine the proportions.
The cost of protection on Treasury paper would also be expected to increase; although initially one would think that the additional cost would be quite modest. After the downgrade in 2011, the Treasury market rallied. The market decided that all the bad news was out at that point. This time, the market may have to digest the news for some more time.
The downgrade cited medium term budget issues and governance concerns. Both are valid points. Budget deficits continue to grow while the debt ceiling issue will not be a concern until 2025 after the election. We would like to think that the budget issues are possible to solve. However, the governance aspects do affect the ability to achieve the result. Social Security and Medicare are generally off the table but we know without addressing the growth in those two critical spending priorities that challenges will ensue. The trusts are poised to be greatly challenged in the 2030’s.
As for the effects on municipals, there may be multiple aspects. Derivatives contracts and some variable rate paper outstanding may need to modify their indentures to accommodate the new rating reality.
Another aspect is the traditional view of the sovereign ceiling. The concept here is that the sub-sovereign ratings, e.g., states and localities could not be rated higher than the sovereign. Over the years, this concept has been modified and exceptions have been granted in some cases. I am not overly concerned about invoking the concept at this point. But the concept is lingering in the background. We do not have currency risk in municipals so we do not have to fret about internal and external status.
Future federal aid to states and localities will also be an important monitoring item going forward.
A most important consideration of the recent downgrade is whether there will be an effect on rates.
Rates have moved up appreciably in recent days with the ten-year Treasury at 4.118%. Some of this increase may be attributable to the rating action.
We have not heard a lot of commentary about the rating action from around the globe at this point. Commentary is likely to be forthcoming. The IMF and others have discussed the USA’s growing debt burden and the negative implications from time to time.
The real critical question to ponder for most participants in the market is whether Moody’s will also be inclined to act. This is an open question with no clear answer in the offing. Having three ratings in the Aa/AA category would be considered more momentous.
The timing of such an important rating action is always subject to criticism. There is no perfect time. One would think that budget adoption time or tax time may be more appropriate. Event driven timing does not allow as much pondering of the result of the rating process.
One precept that should be in place is that this kind of rating action should not be taken when so many key participants are on vacation. I can imagine that the lines of communication are quite active even if the result is that not too many actions will be taken or will be necessary because of the rating action.
John Hallacy
John Hallacy Consulting LLC
08/02/23
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