Credit rating agencies have their say, but don’t overestimate the impact on government borrowing costs.
After Wednesday’s close, credit rating agency Fitch issued a press release saying it was putting America’s AAA credit rating on watch. potential downgrade. The appraiser argues that the “extremity” of the debt ceiling and the failure of a deal so far make it more likely that the Treasury will exhaust its extraordinary funds and miss payments on some “obligations.”[i] While Fitch admits an actual default — a failure to make debt payments — is a “very low-probability event,” it says failure to reach a deal before the end of emergency measures is inconsistent with the company’s AAA rating. Many believe these ratings are crucial to keeping federal debt interest rates low, so it’s attracted a lot of attention and some fear. But we’ve seen many downgrades of sovereignty these days. Such a move could cause short-term volatility in stocks and bonds. But it will probably pass quickly. Why? A downgrade guarantees higher government borrowing costs, not true. Let us show you.
The great irony of the appraiser threatening to downgrade the US is that the government is one of the few reasons people actually follow the work of credit appraisers. The US government created a niche for these “Nationally Recognized Statistical Rating Organizations” in the 1970s, with the idea that bond ratings would help investors assess the creditworthiness of borrowers ranging from corporates to municipalities and, yes, governments. They wrote those ratings into the laws and regulations that govern banks and pensions thereafter, giving the appraisers’ opinions a certain technical dimension.
But, to be clear, these ratings are not the same as your personal credit rating from one of the three major bureaus. A low rating on one of these will likely make your loan more expensive. But governments borrow by issuing bonds. Investors buy them, and most don’t care what the credit scorers think. Why? They can see the profitability in the market. They do their research. They come to their own conclusions and may find values that appraisers do not.
There is also a long history of assessor decisions after market developments or popular news, not leading them. Their work during the financial crisis is the stuff of legend, starting with giving subprime mortgage debt high investment grade ratings that appraisers later called a “bubble.”[ii] court to rate Lehman Brothers and AIG at least ‘A’ (strong rating) by 2008; in late September, just days before both collapsed.[iii] Fitch, for what it’s worth, gave Lehman’s preferred stock an A+ rating in 2008. in April. This is, by the way, a month after the almost identical Bear Stearns failure. But even beyond these widespread problems, consider: Does Fitch’s decision to keep America on watch because the debt ceiling is tough tell you something you didn’t already know?
Because their moves rarely shed new light, they often don’t have the impact that people think. Many people are talking about Standard & Poor’s downgrading America’s debt rating from AAA to AA+ in 2011. But few seem to remember the chain of events. At that time, Republicans and Democrats made a deal in 2011. on July 31. The House of Representatives passed it on August 1; Senate on August 2. Former President Barack Obama signed it on the same day.[iv] (Less than three business days.) However, Standard & Poor’s did not downgrade until August 5. By then, all uncertainty about the debt ceiling was gone. Instead they cited “brinkmanship” (literally the same word). Their reasoning involved a $2 trillion math error that they dismissed as inconsequential after the fact.[v]
All that aside, here’s a chart of what happened after the US 10-year Treasury rate cut. (Figure 1)
Figure 1: Reduction and lowering of Treasury rates
Source: FactSet, as of 5/24/2023. US 10-Year Permanent Maturity Yield, 12/31/2010 – 12/31/2011.
You see that right, the rates has fallen after the downgrade. Now we’ve seen some on financial Twitter argue that it’s because the US dollar is the world’s reserve currency. It is not so. Figure 2 shows the average yield change 60 days before and after Fitch and S&P’s AAA-rated countries were downgraded. On average, Fitch has cut rates by just 0.2 percentage point since the move, and rates have fallen since S&P’s cut.
Figure 2: AAA Discounts and Interest Rates
Source: Fitch Ratings, S&P Global Ratings, FactSet, Global Financial Data, Inc., as of 5/25/2023. Change in 10-year bond yields of issuing countries before and after downgrades.
Furthermore, Fitch’s data represent a smaller set. Fitch has downgraded eight AAA-rated sovereigns, the latest of which was Canada in 2020, and it has never upgraded one, reaching its most sterling. (Oh, and in case you’re wondering, the 10-year Canadian bond yield rose just 0.03 percentage point in the 60 days following the move.) In contrast, S&P downgraded more AAA-rated issuers, including one each for Ireland, Finland and Spain. Show plots 2 from 18 to 19 as we are missing daily return data to cover the 1982 New Zealand downgrade. But regardless of which estimate, the maximum 60-day increase in yield from these APA cuts was 0.68 percentage points, which isn’t very large.
We think it’s overwhelmingly likely that US politicians will get a debt ceiling deal at the last minute. However, we have no opinion on whether Fitch will follow through on yesterday’s warning and downgrade America’s credit rating. In the end, S&P did so despite a pre-contractual deal. But regardless, we doubt that what Fitch thinks about US policy has much bearing on borrowing costs.
[i] “Fitch Puts US AAA On Negative,” Staff Fitch Ratings:24.5.2023.
[ii] “S&P Raises Defense Against US Ratings Case,” Edward Peterson, Bloomberg7/8/2013. Puffer defined as an exaggerated or extravagant statement of praise.
[iii] “Credit Rating Agency Analysts Covering AIG, Lehman Brothers Never Disciplined,” Shaheen Nasiripour, Huffington Post25.5.2011.
[iv] “Debt ceiling. Deal development schedule”, staff, CNN:8/2/2011.
[v] “S&P’s $2 Trillion Mistake Didn’t Change Downgrade Decision,” Steve Lisman CNBC:8/6/2011.