S&P revises its outlook for T-bonds from stable to negative

The S&P announcement

Yesterday the rating agency issued a new “unsolicited” opinion (meaning it wasn’t hired by the US to do so) on US government debt.  While retaining its current AAA rating for Treasuries, S&P has revised down its outlook for the country’s long-terms obligations from stable to negative.

What does this mean?

“Negative” means S&P thinks there’s at least a one in three chance of a credit downgrade within the next two years.

S&P’s reasoning?

The factors S&P considers most important are:

–deterioration of the US fiscal position over the past decade

–damage done by the financial crisis and ensuing recession

–inability of Washington to agree over the past two years on a plan to address these issues

–the “significant risk” that nothing will be done before the election in November 2012.

Although S&P (like everyone else) regards unfunded entitlement programs Social Security and Medicare/Medicaid as the main sources of budgetary woes, it points out that the country may also have to cough up another $685 billion to recapitalize Fannie Mae and Freddie Mac.  S&P observes, as well, that much of the US sovereign debt is concentrated in the hands of a small number of foreign governments, raising the possibility that one or more might change their minds.

be careful what you wish for

It wasn’t that long ago that Congress was lambasting the rating agencies for not being proactive enough in downgrading the exotic credit instruments spewed out by Wall Street.  Their collapse weakened the national finances and made the deficit a “today” issue rather than one that could be safely be put off.

I wonder how Washington likes proactivity now?

And the S&P raters whose integrity was questioned by Congress wouldn’t be human if they didn’t take a kind of satisfaction in calling attention to the fact that the UK–and even France (?!?)–are further along the path to fiscal responsibility than the US.

what happens next?

A lot depends.  I don’t think there’s much anyone can say for sure.

For one thing, not everyone agrees that the S&P analysis is correct.  For example, a comment popped into my inbox at about 6pm on Monday from Jim Paulsen, the chief economist for Wells Capital, arguing that the deficit is primarily cyclical.

It seems to me, though, that the S&P announcement puts additional pressure on elected officials to cooperate with one another.  That pressure would increase if, say, Moodys, were to follow the S&P lead and say something similar.  The debate on raising the federal debt ceiling will give an almost immediate indication of whether the Democrats and Republicans can work together.

No matter what, my guess is that the S&P announcement will turn out to be a significant turning point for US government finances.  Despite the dollar being the world’s reserve currency, I think the days of Washington just willy-nilly issuing news bonds are coming to an end–sort of like maxing out an almost infinite credit line.

Also, if past form holds true (and I think it will), domestic borrowers–not foreigners–would be the first to desert the Treasury market in large numbers.  This means that worry about Treasuries will express itself initially, and primarily, through higher interest rates, not a weaker currency.  Only if the situation becomes really ugly will the dollar come under significant pressure.

From an overall economic perspective, I find the “hidden” loss of wealth through currency depreciation to have worse negative effects than adjustment through higher interest rates and a slower economy.  From a stock market point of view, however, it’s much easier to devise a money-making strategy in a weak currency environment than in a high interest rate one.

Stay tuned.

Issuing 100-year bonds? … the Treasury says “No, thanks.”

the suggestion

Once every three months, the Treasury Borrowing Advisory Committee, whose members come from among the designated primary Treasury bond dealers, makes a presentation to the government on the state of that market.  In the most recent meeting, earlier this week, the TBAC suggested that the Treasury is missing an opportunity to sell to a potentially large segment of bond buyers–$2.4 trillion worth–by sticking with the plain-vanilla bonds it issues now.  Although the TBAC cited callable and variable-rate securities as possible new flavors, its main suggestion was that government issue longer maturity bonds.  It thinks there would be many willing buyers of even 100-year Treasuries.

The TBAC argument in favor of long-duration bonds is economic.  Its main conclusions:

–insurance companies, due to the long duration nature of the risks they underwrite, need a constant supply of high-quality bonds to use as an offset.

–new capital adequacy rules for banks will increase demand from this sector as well.

Three other points were unspoken:

–even private companies have been able to issue very long duration bonds over the past year

–interest rates are at emergency-low levels, so circumstances are very favorable for sellers, and

–the current US issuance strategy, which emphasizes bonds with maturities of three years or less, minimizes the current interest expense of the country’s debt burden, but exposes the government to considerable refinancing risk, as the following data taken from the TBAC powerpoint presentation illustrate:

outstanding Treasury bond maturities

3 years or less       40%
5-7 years                40%
10-15 years            12%
20+ years                8%.

the response

During a subsequent press conference, a Treasury spokesperson said a 100-year bond makes no sense for the US government.  I don’t think this is an economic conclusion.  It’s a political one.

No, I don’t think the Treasury is concerned with potential repercussions from the losses it might be saddling buyers of a 100-year bond with, as interest rates begin to rise.  After all, it continues to sell savings bonds to the (shrinking number of) Americans unwise enough to purchase them.

Instead, I think the Treasury has two main motives in taking the immense refinancing risk its current maturity profile entails:

–with the government paying 1% interest or less on 40% of the outstanding debt, the current outlay to finance the borrowings is much less than it would be with a more prudent maturity schedule ( a 1% increase would add about $140 billion to the budget deficit), and

–in the current, highly partisan political climate, the administration would surely be accused of acquiescing to, or institutionalizing, the current size of government debt by extending maturities.

I guess it makes some sense to argue that the constant need to refinance exerts pressure on Washington to rein in spending.  There’s no evidence I can see in Congressional behavior that would suggest this theory is right, however.  In fact, it seems to me more like the lower interest expense reduces any sense of urgency to rein in deficit spending.