Is the US rating downgrade really a non-event?

S&P in 2011, Fitch in 2023, and Moody’s in 2025! All the three rating agencies have now stripped the US’s issuer rating by a notch below the highest, citing unsustainable debt levels currently at $28 trillion or 98% of the GDP, high fiscal deficit at 6.4% of GDP, rising interest costs of public debt consuming 18% of the revenue, extension of the 2017 Tax Cuts and Jobs Act that can easily add up to $4 trillion to the US fiscal deficits over next decade, and with 75% mandatory spending, a budget that provides very little room to course correct the debt trajectory.

Is this an Armageddon of the US’s exorbitant privilege and treasuries status as a haven? Answer is unlikely in the short run as the US treasury market is still the most liquid, at least at the short-end, and relatively safe, but this event, coupled with the uncertainties the US Government is throwing at the world together has the potential to accelerate the diversification efforts away from the US and the Dollar. In any case, this is not a “non-event” and the US does not have another decade before it seriously starts thinking about the debt woes, as remarked by some experts. Let me explain why.

First, markets are getting increasingly worried about the US downgrades. Markets brushed off the 2011 S&P downgrade, when the US treasury yields rose on the impact of the news but fell dramatically in the next 2-3 days. Markets had a little more cautious reaction after the 2023 Fitch downgrade when yields hardened by 20 basis points on a sustained basis, in a way to suggest that the market had permanently priced the fiscal risk into the treasuries. And this time, the reaction is more severe and across the asset classes: 30-year yields spiked from already high of 4.86% to 5.15% and even after 10 days at the time of writing are at 5.05% level, dollar and equities are down 2%, the gold is up by 3% in a week’s time after the downgrade as investors sought safety. To top it all off, the US Treasury’s recent auction last week of a 20-year maturity bond saw a tepid demand with below-average subscription.

Second, following the Russian central bank, which was always buying gold heavily, other central banks like India, China, and Poland, for example, are buying gold in large quantities, shifting away from the US treasuries at least on an incremental basis, and the purchases are continuing well into 2025. Treasury data shows that India, Brazil, Saudi Arabia, and Japan all have decreased their treasury holdings over the last 12 months. US treasuries now account for 14% of the central bank’s reserves, down from 25% just around the pandemic, with freezing of Russian assets by the US administration turning out to be a catalyst.

Third, there is growing evidence now that the back end of the treasury has been increasingly behaving like risk assets, with 10-year over 2-year term premia widening to 0.88%, levels not seen since 2014. And what may come as a surprise to many is that the safe haven status of the US treasuries has gotten increasingly specific to the short-term treasuries with long-term treasuries witnessing outflows both during the Global Financial Crisis (GFC) in late 2008 and again during Covid when the foreign investors and mutual funds collectively sold-off $420 Bn of long-term treasury bonds in March-2020, and pushed the yields and term premia higher. The Federal Reserve Bank of Dallas’s analysis shows that the net flows into long-term treasury and VIX - the gauge of uncertainty- have a correlation of -0.52 over the last decade, suggesting that long-term treasuries lose capital from foreign investors during times of heightened uncertainty. In other words, long bonds just became a positive beta asset!

With average treasury bond maturity of 71 months compared to 55 at the onset of GFC, long-term yields are more relevant than ever before for determining the borrowing cost of the US government. Mortgages – the bedrock of the US economy, priced directly off the 30-year yields. And if the sell-off in the treasuries due to fiscal worries hardens the yields, the elevated interest costs have the potential to make the fiscal math even worrisome feeding back into the sell-off, setting off a vicious cycle.

Higher long-end US yields have the potential to compete away the bond inflows into India’s 10-year Government bonds and make external commercial borrowings costlier, especially of longer tenor used for infrastructure financing and on-lending by NBFCs. The carry trades could be unwound to some extent, but most of these hinge upon very short-term tenor treasury derivatives and may be less exposed to term premia widening.

A lot of what is happening around us could be noise, but part of that surely becomes a structure going forward!

(The author is the Chief Economist at Muthoot FinCorp Ltd)