The dictated debt limit deadline looms and a credit rating downgrade, to US Treasury securities and agency mortgage-backed securities, seems likely. Naturally, a spike in treasury yields is expected and a subsequent rise in mortgage rates should follow. That’s right out of the senior year textbook, in most American business schools.
I’m not so sure the fixed-income markets will follow the textbook. Mortgage rates might … do nothing in response the the credit rating downgrade. Here’s why:
The credit ratings agencies lack……well…credibility.
The independent credit ratings agencies ( Moodys, Standard & Poors, Fitch, etc) have a reputation for being late on the scene. They got hoodwinked with Enron, MCI/Worldcom, and Greece. They were asleep at the wheel during the mortgage meltdown, issuing AAA ratings to CDOs, up until late 2007. They are often considered to be too chummy with the issuers (the issuers pay their fee) and when the issuer is a government (with the power to regulate their business), they generally walk on eggshells.
The news may be baked into the market already.
The ratings agencies have been signaling a potential downgrade for months. Clearly, raising the US debt limit will allow the Treasury to remain “liquid” but the agencies have said a downgrade is likely unless a substantive plan is enacted to reduce spending. Cut, Cap & Balance, the “most extreme” of the proposals offered, still might not have been “extreme” enough to avoid a downgrade. Both political parties are demonstrating that they lack the political will to address the long-term structural deficits, needed to bolster the Federal budget, to avoid the ratings downgrade. Fixed income traders seem to be shrugging that off.
US Treasury securities are still considered to be the safest investment in the world.
Certainly there are better run countries than the US but their debt offerings lack SIZE; there ain’t enough of that debt for the real money. Germany has its EU obligations hanging around in the background and Japan seems to be in worse shape than we are. Chinese sovereign debt could be a consideration but the Chinese and Japanese still want their investments dollar-denominated. The US is, for all purposes is “too big to fail”. While a world-wide bailout, under the auspices of the IMF seems unlikely, a de facto bailout, by countries who have no other place to park their cash, will probably happen. As paradoxical as it might sound, the ratings downgrade might attract more money because it affirms that while the US is getting ugly, we’re still the prettiest girl at this dance.
Domestic institutional investors are married to the US Treasury.
Insurance companies, state pension funds, union pension funds, banks, and credit unions are bound by charter to invest a certain amount of assets in US Treasury securities or agency derivatives. Banks are amending their charters to read that they “must invest in AAA securities or government debt” this week, to facilitate the downgrade. If you can’t be, with the one you love, baby, love the one your with.
Rebalanced portfolios could attract more money to US Treasuries
A downgrade will most likely affect the credit markets through the overnight borrowing market (where short-term treasuries are used as collateral). This could hamper the availability of private sector lending a bit which could be detrimental for domestic equity markets and corporate fixed income issuers. Subsequently, portfolio managers might rebalance their portfolios by trimming back on stocks and corporate bonds, and seek a “safe haven” with the proceeds. That safe haven may be the very asset class which caused the mess. Go figure.
The Fed might just continue to be…The Fed.
I’ve given up on trying to figure this creature out. The Fed does crap I never knew it could do (well, because it never could do what it’s done these past few years). The Fed could announce QE17 and start bidding 102 for the new treasury auctions, with the sole intent of “fooling” other investors into thinking the issue is in high demand. Please don’t tell me I’m a conspiracy theorist; the Fed has transparently operated outside of its charter for AT LEAST 3-4 years now.
Another thought is that the spread between mortgage-backed securities and treasuries could narrow after a downgrade. The bad news buried in the back of the breadbox is tempered by the fact that the MBS market has a
sugar daddy rich Uncle Fred and Aunt Fannie, which continue to be wealth redistribution conduits. Traders might figure that the profitable loans stay in the MBS pools while losses are laid off on the Treasury. If this theory gets traction, mortgage rates could be flat or actually go down.
None of this makes any sense but, in the world of “too big to fail” it ain’t supposed to make sense…it’s just the “right thing to do”. Right?
Call me Alfred E Neumann but I’m not too worried.17 comments