As an investor, you probably noticed, among the screaming headlines and constant media coverage, that the Standard & Poors bond rating division has threatened to downgrade the credit rating of U.S. Treasury bonds. The U.S. markets dropped 1% almost immediately after the news broke, and the S&P 500 index of large cap stocks finished the day down 1.1%.
What was not always emphasized in the news coverage is that this is far from an actual downgrade. The announcement actually said that Treasury securities would be given a AA rating (the credit rating of Japan) rather than the current AAA (the highest credit rating, which is also enjoyed by France and Germany) if the federal budget deficit is not addressed within two years.
Coming from the same organization which, in 2008 and before, gave AAA ratings to subprime mortgage debt instruments, this credit evaluation might be dismissed–except that other parties seem to be equally worried. Large bond investors noted that sustained deficits in the US would cause global investors to demand higher interest rates on government debt. Higher rates on new issues would cause the value of existing bonds to fall.
But why are stocks falling when the conversation seems to be all about bonds? Investors may be worried that any rise in interest rates would raise the borrowing costs across Corporate America as the U.S. economy is still rebuilding from the Great Recession. But there may also be some concern that stocks haven’t fully factored in all the bad news around the world: Japan -the third largest economy – pounded with an natural disasters and continuing aftershocks of nuclear problems; the Middle East -where most of the world’s oil comes from- seething with unrest; Portugal, Greece and Ireland requiring Eurozone bailout for its sovereign debt. Closer to home, estimates of GDP growth dropping below 2%.
Looking at all this uncertainty, you might think getting out of stocks is a good idea. The problem, of course, is finding a good place to redeploy that money. Should you pay Treasury bonds? Global Stocks? CDs at less than 1%? The global economic uncertainty actually causes an inflow into the US market. Seen as an island of relative calm, the US has typically benefited from investor fear and a flight to quality. So don’t jump ship yet.
Any hint that the U.S. government will lose its best-in-the-world credit rating is likely to be sensationalized, even if the event won’t take place for another two years, even if it is conditional on no action being taken between now and then. If the government’s cost of borrowing does go up from the current 3.40% on 10-year Treasuries, it would unhelpfully raise the cost of financing our nation’s debts. But the news media never seems to provide a full perspective on these banner headlines. Japan’s sovereign debt is, proportionately, higher than America’s, and Japan received the dreaded credit downgrade to AA status earlier this year. That caused Japan’s borrowing costs, on its 10-year securities, to go up incrementally–to, currently, 1.29%.
We have other concerns with US Treasuries which we will get into in a later blog.