Fitch Downgrade And What It Means For Institutional Investors

As the US debt ceiling drama continues, credit rating agencies are taking to downgrade the US. This development has caused widespread concern, and many fear the potential consequences for investors and markets. However, it is crucial to take a step back and assess the implications of the downgrade in a rational and informed manner.
 
Fitch Ratings, the agency behind the downgrade, cited prolonged discussions on the debt ceiling as evidence of a “deterioration in the standards of governance.” Additionally, Fitch anticipates an economic downturn that could further weaken the government’s financial position.
To understand the impact of the downgrade, it is essential to grasp the unique nature of the US government’s budgetary operations. Unlike a household budget, the government does not need to find money before engaging in deficit spending. Instead, the government, as the issuer of its currency, creates money that circulates in the private sector. Deficit spending increases net wealth, creating bank deposits in the system.
 
The rise in debts and deficits has significant implications for debt yields. As the US government continues its spending spree, it borrows more to fund expenses, which puts upward pressure on debt yields. Investors demand higher yields to compensate for the added risk associated with holding more debt. The increased borrowing costs divert more tax dollars away from productive investments, potentially hindering economic growth.
 
The surge in debts and deficits also raises concerns among investors about the sustainability of government finances. In response, they may demand higher yields on government bonds to protect against the possibility of default or inflation eroding the value of their investments.
 
Higher debt yields have broader implications for the economy. As government borrowing costs increase, it becomes more expensive for the government to service its debt, which can lead to reduced funding for essential programs and services, further hindering economic growth.
Furthermore, rising debt yields can have a ripple effect on other interest rates in the economy. As government bond yields rise, it puts pressure on other interest rates, including mortgage rates and corporate borrowing costs. Higher interest rates can dampen consumer spending and business investment, further restraining economic growth.
 
It is crucial for policymakers to address the root causes of rising debts and deficits to mitigate their adverse effects on debt yields and the broader economy.
Looking at how the downgrade affects investors and market participants, it is essential to analyze the rating requirements that various institutional players must adhere to when investing in safe government bonds.
 
Commercial banks are among the largest buyers of Treasuries, using them as regulatory liquid assets, collateral, and sometimes as assets to hedge interest rate risk on their liabilities. The Basel regulatory framework introduced 10 years ago has 0% capital requirements for government bonds rated between AAA and AA- under its standardized approach. As a result, the downgrade to AA+ wouldn’t make any difference for banks.
 
Additionally, most banks choose an internal-rating-based (IRB) approach based on internal models, and in that case, most jurisdictions apply an exception for any investment-grade rated domestic government bond, which automatically assigns them a 0% risk weight. Therefore, for banks, this downgrade has no material impact.
 
Similarly, pension funds and insurance companies, significant buyers of Treasuries, use them as long-duration assets to match their long-term liabilities. For pension funds, considerations about risk/return profile are important, but a one-notch downgrade from AAA to AA+ would not significantly change their approach to asset allocation.
 
In the repo market, where pension funds and insurance companies lend their unsecured cash against collateral to upgrade the safety of their deposits, the downgrade is unlikely to have a significant impact. Bonds rated between AAA and AA- fall within the same bucket, making the marginal effect of the downgrade minor.
 
Another critical player in the market is FX reserve managers. When foreign entities sell goods to the US and receive US dollars, they deposit these dollars in their domestic banking systems. Subsequently, central banks like the Bank of China and the People’s Bank of China invest these US dollars in safe and liquid assets, such as US Treasuries.
 
For FX reserve managers, rating considerations are essential, but most countries place AAA-AA rated governments in the same risk bucket. Moreover, as 70%+ of global transactions are still conducted in USD, there will always be a structural demand to recycle these USDs in safe US Treasuries. The limited alternatives available make US Treasuries an attractive and safe option for FX reserve managers.
 
In summary, we think the downgrade has no material impact that would force institutional players to sell off their US Treasuries.

 

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