Is the US at risk from a credit rating downgrade?

If you cast your mind back to 2011, the last time the debt ceiling was a potential issue for financial markets, it was rating agency Standard & Poor’s move to strip the US of its triple A credit rating that triggered a major sell off in global stock markets and a rush to safe haven assets. In the aftermath of the US downgrade, the S&P 500 fell more than 15%. So will the US be downgraded this time round?

So far two rating agencies have issued statements about the US debt ceiling debacle: Moody’s and Fitch. Both of these agencies still rate the US as triple A and both agencies expect the US Congress to reach a deal to end the political impasse and raise the debt ceiling. However Fitch, who released a statement last Thursday, said that it will consider placing the US on rating watch negative if the government has not raised the federal debt ceiling “before the Treasury exhausts extraordinary measures and cash reserves on Oct. 17th.”

However, an actual rating downgrade from Fitch will depend on how the US government can prioritise payments. A widespread and prolonged delay of payments to suppliers of goods and services to the Federal Government, including salary payments to Federal employees, would “not in itself constitute an event of default from Fitch.” However, it will recognise a sovereign default event if the government “failed to honour interest and/or principle payments.”

The key for rating agencies is a country’s “willingness to pay”, thus, the US could avoid the worst outcome of further rating downgrades even if we hit the debt ceiling this week.

Problems arise if the debt ceiling is not increased in the long-term, which could start to have a detrimental impact on the economy, which in turn could threaten the US’s ability to raise enough revenue to pay off its interest and principle payments. Thus, even if hitting the debt ceiling in the next few days is not quite the calamity some expect, it still leaves the US in a precarious position.

At the time of writing no decision had been taken to raise the debt ceiling. A temporary extension is positive in the near-term as it would make a default event and thus a downgrade less likely, however it would only kick the can down the road and it would still leave the prospect of a US credit downgrade a real possibility.

Interestingly, although the rating agencies are willing to be patient with the impasse up on Capitol Hill, the markets appear to have delivered their own “downgrade” to the US. The short end of the US Treasury curve was under severe pressure last week, with the yield on the 1-month Treasury bill rising to its highest level since 2008 at one point. Usually very near-term Treasury yields move 1-2 basis points a day, however last week they moved more than 30 basis points in just one session. Although yields had retreated by the end of last week, yields on Treasuries that mature at the end of November had started to rise as that is when a temporary extension to the debt ceiling may be reached.

If the debt ceiling is reached and there is still no deal then we would expect yields on Treasuries with a maturity of less than 2 years to rise sharply as the market ditches short-term US debt. Thus, if the US does hit the debt ceiling this week and the rating agencies do not downgrade the US, the market may take matters into their own hands and demand a higher reward for holding US government debt.