The rating agencies and America’s debt ceiling

2012-DEC-06

In the summer of 2011, as the United States government approached its supposed “debt ceiling”, there was a raucous debate in Washington. The highly publicised (and politicised) nature of the battle captured the market’s attention and cast a spotlight on American profligacy. It also clearly showed that there was no legitimate plan going forward to significantly address the government’s severe debt problem.

One interesting side effect of the process was that the credit ratings agency Standard & Poor’s decided to downgrade the USA’s sovereign credit rating from AAA to AA+. With the US government on course to hits its new limit early next year, is another downgrade coming?

Based on commentary made by S&P at the time of the first cut, another one from them could well be possible. Below is an excerpt from S&P’s statement at the time of the downgrade:

“The downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.

“The outlook on the long-term rating is negative. We could lower the long-term rating to 'AA' within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case."

With the exception of higher interest rates, all of the above points still apply. S&P also cited certain conditions that had to be met in order to avoid a further downgrade, and none of them are being met or are likely to be met in the future. None of the proposed cuts have been made (the Congressional “super committee” failed to agree to a deficit reduction programme), and there has been talk of undoing the supposed mandatory cuts that were agreed to during the last debt ceiling increase. The impending fiscal cliff at year-end makes it more unlikely that any deficit reduction will take place. If S&P felt that the effectiveness, stability, and predictability of American policymaking was unstable from April through August 2011, there doesn’t seem much rational basis for concluding that policymaking in Washington has got anymore stable since – though now that the elections are out of the way, we do at least have some stability on that front.

The news that the US government is not a top grade credit has been clear to most for quite some time, but to see one of the agencies make the move was significant. Shortly after the downgrade, the Justice Department launched an investigation into S&P’s ratings of subprime mortgage securities. Given that Moody’s and Fitch made many of the same general mistakes during the subprime boom, one wonders why S&P were the only firm targeted. Will this investigation influence their future decisions regarding US sovereign debt? Given the precedent they’ve set by their last downgrade, S&P are in a tough spot: if they announce further downgrade(s), they risk the wrath of Washington; but if they don’t then they risk losing credibility in the eyes of investors.

With the fiscal cliff and debt ceiling debate approaching, it’s time again to keep an eye on the rating agencies. The whole notion of sovereign credit ratings – as if countries were just big corporations – may be dubious, but rating cuts still have the ability to move markets. We saw this in dramatic fashion with the gold price following S&P’s US rating cut at the start of August last year. Another such cut, and gold could again be off to the races in a big way.