Bloomberg News

U.S. Downgrade Seen as Upgrade as U.S. Debt Dissolved

October 09, 2012

Downgrade of U.S. Seen as Upgrade as $4 Trillion Debt Dissolved

Reduced borrowing means there is less competition for the U.S. Treasury Department as it sells debt to fund spending programs to help the nation recover from the worst financial crisis since the Great Depression. Photographer: Andrew Harrer/Bloomberg

U.S. debt has shrunk to a six-year low relative to the size of the economy as homeowners, cities and companies cut borrowing, undermining rating companies’ downgrading of the nation’s credit rating.

Total indebtedness including that of federal and state governments and consumers has fallen to 3.29 times gross domestic product, the least since 2006, from a peak of 3.59 four years ago, according to data compiled by Bloomberg. Private- sector borrowing is down by $4 trillion to $40.2 trillion.

Reduced borrowing means there is less competition for the U.S. Treasury Department as it sells debt to fund spending programs to help the nation recover from the worst financial crisis since the Great Depression. Credit-rating firms are discounting the improvement even as debt, equity and currency markets suggest the U.S. is more creditworthy than before Standard & Poor’s stripped the nation of its AAA grade in 2011.

“Most people don’t pay much attention to ratings when it comes to Treasuries, as they are still considered to be risk- free assets,” Donald Ellenberger, who oversees about $10 billion as co-head of government and mortgage-backed securities at Federated Investors in Pittsburgh, said Oct. 5 in a telephone interview. “Until that perception changes Treasuries will continue to be” in demand, he said.

Record Bids

The U.S. government, which is selling $66 billion of three-, 10- and 30-year bonds this week in three auctions starting today, has attracted a record $3.16 in bids for each dollar of the $1.59 trillion of securities it has sold in 2012, according to data compiled by Bloomberg. That exceeds the previous high of $3.04 set last year. The U.S. sale of $32 billion in three-year notes today was met with record demand.

Deleveraging in the private sector may allow households to boost spending, which accounts for about 70 percent of the economy, and increase their capacity to pay taxes. Household wealth in the U.S. rose to $62.7 trillion as of June 30 from $51.2 trillion in early 2009, the Federal Reserve said Sept. 20.

Rising wealth would bolster the ability of the government to service its debt, even after the amount of Treasury securities outstanding soared to a record 71 percent of GDP from 36 percent five years ago.

Yields on 10-year Treasuries rose 11 basis points last week, or 0.11 percentage point, to 1.74 percent, according to Bloomberg Bond Trader data. The price of the benchmark 1.625 percent note due August 2022 fell 31/32, or $9.69 per $1,000 face amount, to 98 30/32. The yield was 1.71 percent at 8:49 a.m. in New York.

Downgrade Rejected

Even with last week’s increase and the jump in marketable Treasuries outstanding since 2007 to $10.8 trillion from $4.5 trillion, 10-year yields are down from 2.56 percent when S&P cut the U.S. one step to AA+ on Aug. 5, 2011. Egan-Jones Ratings Co. has downgraded the nation three times since July 2011, assigning it a AA- ranking on Sept. 14. Moody’s Investors Service said it may follow suit next year if the government can’t decide on a plan to reduce federal debt to GDP.

Downgrading the U.S. is premature when the two-thirds of American debt that is private is shrinking, according to Jim Vogel, head of government agency-debt research at FTN Financial in Memphis, Tennessee.

“When one trend goes counter to the only one that they seem to be looking at, that throws up a flag,” Vogel said in a Sept. 27 interview in reference to the ratings firms. “If private debt is getting on a much firmer credit foundation, why do we have a 2013 deadline for one of the thorniest fiscal problems of an entire generation?”

Fiscal Cliff

The U.S. faces a so-called fiscal cliff of $1.2 trillion in mandated spending cuts and tax increases starting Jan. 1 if Congress can’t agree by Dec. 31 on ways to reduce the deficit.

America’s ability to weather the potential drop in fiscal stimulus and rise in taxes improved last week, as the Labor Department said unemployment fell to 7.8 percent in September, the first time it was below 8 percent since January 2009.

A Pew Research Center survey of likely voters conducted Oct. 4 to Oct. 7 gave Republican nominee Mitt Romney a four- percentage point lead over President Barack Obama. A Gallup poll of registered voters Oct. 1 to Oct. 7 showed Obama advancing over Romney by five points one day after, in a shorter tracking survey of three days immediately following their Oct. 3 debate, it called the race a tie.

“We’re seeing a good debate for Romney, a good jobless number for Obama and I don’t think that fundamentally changed the race,” said Evans Witt, chief executive officer of the nonpartisan Princeton Survey Research Associates.

Growth Forecasts

While economic growth is forecast to slow to 2.1 percent in 2013 from 2.2 percent this year, that would still be better 0.5 percent contraction in the euro area, the 1.2 expansion in Japan and the U.K.’s 1.2 percent growth, separate surveys of economists by Bloomberg show.

When assessing the strength of U.S. credit, “you have to look more broadly than simply the debt-to-GDP ratio,” Zach Pandl, the Minneapolis-based senior interest-rate strategist at Columbia Management Investment Advisers LLC, said Oct. 1 in a telephone interview. The firm oversees about $166 billion in fixed-income assets.

Bloomberg compiled quarterly data on federal, non-financial corporate, financial company, state and local government and household borrowing from the New York Fed and Washington-based Fed and compared that with year-end figures earlier than 2011. The gross-domestic-product data is from the Bureau of Economic Analysis.

Declining Debt

Consumer debt declined to $11.4 trillion at the end of the second quarter, from a peak of $12.7 trillion in 2008. The market for commercial paper, a form of short-term corporate IOUs, has shrunk to $975 billion from a record $2.22 trillion in July 2007, central bank data show.

Net U.S. taxable debt issuance, which includes corporate, mortgage and Treasury securities, is forecast to fall to $821 billion in 2012, the least since 2000 and less than half the record $2.28 trillion in 2007, according to Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York. The firm is one of 21 primary dealers that trade directly with the Fed and is obligated to bid at Treasury auctions.

‘Notable Improvement’

“All you have to do is look at the total debt to GDP to see that there’s notable improvement since the crisis of 2008,” Jeffrey Caughron, an associate partner at Baker Group LP in Oklahoma City, said Oct. 3 in a telephone interview. The firm advises community banks on investments exceeding $42 billion.

S&P cited political risks and the worsening “likelihood that Congress and the Administration will agree upon a credible, medium-term fiscal consolidation plan in the foreseeable future” when it downgraded the U.S.

After the Treasury Department said S&P made a $2 trillion error in its calculations, the ratings company switched the budget projections it was using and proceeded with the downgrade. S&P denied it made a mistake and said using the government’s preferred fiscal scenario didn’t affect the credit rating.

Moody’s and Fitch Ratings give the U.S. their top rankings. Like S&P, the firms have a “negative” outlook on the U.S.

Private-sector debt is considered in S&P’s economic and external indebtedness scores, which are among the five factors it uses to consider a nation’s creditworthiness. S&P’s calculation of its sovereign debt-to-GDP ratio includes state- and local-government debt, according to the company’s rating criteria.

Moody’s View

“As our reports indicate, despite increased revenues from anticipated GDP growth, there isn’t a plausible scenario for the U.S. to grow its way out of the deficit,” John Piecuch, a spokesman for S&P, wrote Oct. 5 in an e-mail.

Moody’s said its Aaa rating for the U.S. will probably be cut one level next year unless the government agrees on a plan to reduce the ratio “over the medium term.” The firm considers debt levels in the whole economy in its sovereign ranking, said Steven Hess, the senior vice-president and lead analyst covering the U.S. at Moody’s in New York.

“As the household deleveraging goes on, because consumption is the biggest part of GDP, as long as that continues it’s harder for the federal government to reduce its deficit, to reduce its debt ratio,” Hess said Oct. 3 in a telephone interview.

‘Serial Offender’

Sixty-seven percent of 1,031 global investors in a Bloomberg Global Poll in September 2011 said S&P’s move was justified. Pacific Investment Management Co.’s Bill Gross, who runs the world’s biggest bond fund, said last week the U.S. will no longer be the first destination of global capital in search of safe returns unless fiscal spending and debt growth slows.

“The U.S., in fact, is a serial offender, an addict whose habit extends beyond weed or cocaine and who frequently pleasures itself with budgetary crystal meth,” Gross, who manages the $277.7 billion Total Return Fund (PTTRX:US), wrote in his monthly investment outlook posted Oct. 2 on Newport Beach, California-based Pimco’s website.

Gross eliminated government-related debt from the Total Return Fund in February 2011 and said in March of that year that Treasuries needed to be “exorcised” from portfolios. The fund lost against 70 percent of its peers that year, prompting Gross to capitulate and buy U.S. government debt. The company’s flagship fund has beaten 97 percent of its peers this year, Bloomberg data show.

Dollar, Stocks

Treasuries returned 9.8 percent in 2011, the most since 2008 when including reinvested interest, Bank of America Merrill Lynch Indexes show, as yields overall have fallen 43 basis points to 0.96 percent since the S&P cut.

IntercontinentalExchange Inc.’s Dollar Index (SPX), which tracks the currency against those of six major trading partners, has climbed 6.7 percent since the cut to 79.55, above its average for the past five years of 78.96. The S&P 500 Index has rallied 24.5 percent including dividends.

Credit-default swaps tied to U.S. debt, which typically fall as investors’ perceptions of creditworthiness rise and increase as they deteriorate, have fallen to 41.2 basis points from 55.4 basis points on the day of S&P’s downgrade and a record 100 in February 2009, according to data provider CMA. The firm is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market.

Toss Up

Predicting the reaction to rating changes by S&P or Moody’s is little more than a toss up, with yields moving in the opposite direction than suggested 47 percent of the time, according to data compiled by Bloomberg in July. Yields were measured after a month relative to U.S. Treasury debt, the global benchmark.

The U.S. isn’t the only nation to see its bonds rally after a downgrade. France’s 1.08 trillion euros ($1.40 trillion) of debt maturing in a year or more gained 8 percent since it was cut by S&P to AA+ on Jan. 13, more than double the gains for the rest of the global government-bond market.

Ratings companies, which a congressional panel said helped ignite the financial crisis by inflating grades on securities backed by subprime mortgages, are no longer trusted by the world’s biggest investors, according to the former head of structured finance at S&P.

David Jacob, who was fired from S&P in December, said in a June interview that grading government bonds is outside ratings companies’ traditional areas of expertise because “you’re talking about politicians, you’re talking about legislators, you’re not talking about credit risk.”

To contact the reporter on this story: John Detrixhe in New York at jdetrixhe1@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net


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