As the sloppy maneuvering toward a debt-ceiling increase drags on in Washington, investors increasingly expect the U.S. to lose its AAA credit rating, even if lawmakers strike a deal and avert a default.
“While the likelihood of a debt deal flaps in the political hot air of Washington, the chance of a U.S. downgrade increases daily,” Jack Ablin, the chief investment officer of Harris Private Bank, wrote in a note to clients Wednesday. “Our latest estimate pegs the chance of a downgrade at just over 50 percent.” That dour sentiment was also echoed by money managers at powerhouse firms such as BlackRock and PIMCO.
The U.S. has never suffered a downgrade before, so the economic consequences for the county, and the world, remain unclear. It is increasingly clear though that the economic recovery is growing more tenuous and the rosy growth forecasts for the second half of the year haven’t come true. The Federal Reserve’s Beige Book report released Wednesday showed slower growth across much of the country in recent weeks. And the Commerce Department reported that durable goods orders fell by 2.1 percent in June, a disappointment compared with the 0.5 percent increase economists had expected.
S&P and the other credit-rating agencies threatening to knock the U.S. down a peg have been the subjects of much scorn and ridicule in the wake of the 2008 financial crisis, given their assessments of mortgage-backed securities that turned out to be much riskier than their ratings ever suggested. But the agencies’ ratings remain hugely influential and a downgrade of U.S. debt could have painful and wide-ranging effects on the economy.
Standard & Poor’s, one of three major credit-rating agencies, warned earlier this month that there was a 50 percent chance it would cut the U.S. government’s AAA rating within three months if Congress and the Obama administration failed to find “a credible solution to the rising U.S. government debt burden.” (The other major credit-ratings agencies have issued similar warnings.) In announcing they were placing the country on credit watch, S&P analysts indicated that a deal that slashed deficits by $4 trillion over the next decade would allow the U.S. to keep its sterling rating.
On Wednesday, though, S&P President Deven Sharma told a House Financial Services panel that some of the plans now being debated by lawmakers would be enough to avoid a downgrade—and that a package of less than $4 trillion in cuts over the next 10 years could still allow the U.S. to keep its AAA rating. He did not, however, offer more specifics about what level of cuts would be necessary.
In his address to the nation Monday night, the president merely hinted at the possible consequences of a downgrade. "For the first time in history, our country's AAA credit rating would be downgraded,” he said, “leaving investors around the world to wonder whether the United States is still a good bet."
The reality may be significantly harsher. Investors may not lose their appetite for U.S. bonds, even if they are rated AA. Even so, the costs associated with a downgrade could run well into the billions—and would be harmful to an economic recovery that is already proving tenuous. The federal government would have to increase the rates it pays on its debt, and those higher rates would extend across the financial markets.
Institutions that only hold AAA-rated bonds would be forced to sell. State and municipal governments would face higher costs. And consumers would have to pay more for their borrowing as well. "It's hard to measure, but I think you're right to worry," David Wilson, chief national bank examiner at the Office of the Comptroller of the Currency said in describing the effects of a downgrade before the congressional panel Wednesday. "It could be a big thing."
Many companies are reportedly already preparing for the worst, scaling back their hiring and spending plans and instead boosting their cash reserves. And after seemingly shrugging off the drama in Washington over the last few weeks, investors have shown more signs of concern too. The dollar has fallen as currency traders move to other traditional safe havens such as the Swiss Franc and the Japanese Yen. And stocks traded lower Wednesday for the fourth straight session. The Dow Jones Industrial Average dropped 198.75 points—or 1.59 percent—to 12,302.55. The Nasdaq and Standard & Poor’s 500 indices each tumbled more than 2 percent.
The Dow has shed more than 3 percent over the last four trading sessions, while the S&P has lost 2.6 percent this week. Stocks in the banking sector, which would of course be particularly sensitive to any default or interest-rate shock, suffered steep losses Wednesday, with shares of Morgan Stanley down nearly 4 percent, Citigroup and Bank of America each down more than 3 percent, and Goldman Sachs and JPMorgan Chase both losing about 2 percent.
While yields on U.S. Treasuries still hover around 3 percent—low by historic standards—a government auction of $35 billion in five-year notes on Wednesday saw those short-term rates edge slightly higher, suggesting lower demand from investors. Changing yields also suggest that investors are increasingly favoring corporate bonds over U.S debt. Even so, “while yields are ticking up today, the absolute level still implies a debt deal within the next week or two,” Equity Strategist Peter Boockvar of Miller Tabak wrote in a note to clients.
The question remains, will that deal be enough?