According to the internet, Denmark and the US are the two industrialized nations that have legislated ceilings which set an absolute amount above which the national debt can’t rise. Other countries have similar rules, some hard and fast, some not, that limit aggregate government borrowing to a percentage of GDP. 60% seems to be the most-used figure.
The US is now approaching the limit, as it periodically does. Inflation, if nothing else, is getting us there. Janet Yellen says that in early June we’ll likely reach the point where the government may not borrow to continue to pay for government operations or to pay the interest on existing federal debt.
The usual result of this situation is a lot of political theater, followed by a temporary resolution.
In 2011, however, Standard and Poors downgraded US Treasury debt from AAA to AA+, on the idea that Washington was failing to address the long-term issue of rising government debt and continuing budget deficits.
Back then, the S&P downgrade was significant for two reasons. The first was for what the downgrade said about government debt in the world’s most important currency. The second is more technical, but it least as important, I think. Clients of professional money managers almost always (I’m inclined to delete the almost, but there may be some weird exception) have very specific contracts (the prospectuses of mutual funds and ETFs are an example) that state what securities may be held by the client account. What happens with an account where the contract specifies a certain proportion of bond holdings must be in AAA-rated securities.
In 2011, S&P downgraded, but the other two significant rating agencies–Moody’s and Fitch–retained their AAA designation. Back then, one could argue that in some technical sense Treasuries were still AAA securities, since although the most important rater downgraded, the majority was still AAA. So no action was needed.
What happens if Moody’s or Fitch, or both, downgrade now?
We can already see that foreign national banks have shifted away from Treasuries toward gold over the past several months. Maybe bond managers have as well. Presumably also prospectuses and other contractual documents have been made more wishy-washy since 2011. But maybe not.
I think investors of all stripes recognize that the big threat to the stock market is a downgrade, which produced a 7% market decline back in 2011. But I wonder what happens to bonds if we see another downgrade this time.