When the Safe Haven is No Longer AAA

Abstract

The U.S. debt ceiling situation remains fluid, but we believe that a U.S. default is an extremely remote possibility. A ratings downgrade from AAA may be more likely due to the diminished prospect of a credible deficit reduction path. Market implications of such a downgrade may be greater than merely higher borrowing costs for the government. Investors should cope by focusing on their cash portfolio liquidity and investment policy compliance. Although market adjustments to the U.S. losing its AAA rating may be painful, we believe that Treasuries will continue to have a deep, liquid and functioning market.

Introduction

At the time of this writing, the U.S. debt ceiling situation remains fluid. The market generally agrees that measures will be taken in time to increase the ceiling and avert a technical default of Treasury debt. We think, however, that the Washington brinkmanship has done more long-term damage to the credibility of U.S. government debt than the politicians intended. We believe that a potential downgrade of the AAA U.S. sovereign rating is a more likely threat to the debt markets than a technical default of Treasury debt. And time is running out.
What is the likelihood of the U.S. losing one of its AAA credit ratings? What are the likely market implications of such an occurrence? More importantly, how would such a downgrade affect corporate treasury investors, and what are the steps one may take today to prepare for this potential outcome? Sharing the same concerns as most institutional cash investors, we want to use this opportunity to express our views in hopes of helping investors navigate today’s turbulent currents.

In Our Opinion a U.S. Default is an Extremely Remote Possibility

We should note that the U.S. is not Greece. The U.S. government’s ability to service its debt or honor its obligations is not impaired. Nor do near-zero short-term Treasury yields suggest this could occur. The $14.3 trillion debt ceiling, an arbitrary but fiscally responsible constitutional requirement, reflects fundamental significance neither on the U.S. indebtedness nor its fiscal health.
Political leadership is committed to raising the debt ceiling. Treasury Secretary Timothy Geithner sent a letter to Congress on May 16 alerting it that the country had reached its statutory debt limit and that the government has until August 2 to raise the $14.3 trillion debt ceiling or risk not being able to make certain payments on its debt . According to the Congressional Research Service, the debt ceiling has been raised 74 times since March 1962. Political leaders, including President Obama, Congressional Democratic and Republican leadership and the Treasury Secretary, have acknowledged the grave market and economic consequences of a failure to increase the ceiling. The political process relating to lifting the debt limit has the unfortunate timing of happening just before the 2012 election season. Fiscal agreements of the scale being discussed usually come at the last possible moment with twists and turns on the way.
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