Pitching a Fit(ch)

The debt ceiling debate seems to have become somewhat of a tradition, and, after Fitch’s recent warning, so have credit ratings agencies’ threats to downgrade the US if the debt ceiling isn’t solved satisfactorily. Fitch’s announcement isn’t far off (or really much different) from the same warnings the US faced from Standard & Poor’s before their US downgrade in August 2011. Following that, across the board, US debt rates fell (and remain still very low)—not what you’d expect if markets thought the US a worse credit risk. Since Fitch’s threat is essentially the same previously given by Standard & Poor’s, we anticipate a similar fallout (i.e., small to none) if Fitch does indeed downgrade the US, due to ...

The debt ceiling—currently set at $16.4 trillion (which likely has already been breached) by Congress. Fitch fears if the debt ceiling isn’t raised by the very precise target of sometime in February or March, the US will default. Hence, Fitch says, to avoid a downgrade, raise the ceiling. Easy enough to see why someone might downgrade the US if it defaults. However, this presumes first that the US will default if this (rather arbitrary) deadline isn’t met. But it very likely won’t. The US can (and has before) prioritized spending to put debt obligations first. And tax revenues are more than sufficient to cover debt payments plus some. Plus no senator up for re-election in 2014 wants to be viewed as responsible for a default.

In our view, the debt ceiling will be raised at the last minute (as it has in the past)—though it’s unlikely to be raised by such a significant amount that it won’t be used as a wedge issue for congressmen seeking re-election (and re-election cash) in the not-too-distant future. It seems even Fitch expects the same outcome. Hence their caveat a downgrade could still occur if the debt ceiling debate isn’t solved to a degree they find satisfactory. Why? They view political back-and-forth as threats to US bond and global financial markets. (We view such political grandstanding as “business as usual,” but never mind.)

Even if the debt ceiling gets raised (supremely likely) and Fitch still downgrades the US (possible), the history of AAA downgrades and subsequent rate moves suggests markets will view US debt very much as they did before—as the world’s hugest and deepest credit market that’s still supremely credit worthy. (Interestingly, on the day Fitch threatened to downgrade, US rates finished the day effectively unchanged.)

As for fears some institutions will have to swap out US debt to satisfy requirements for AAA debt, we’d say, if a downgrade happens, it’s likely rules get bent—as has been done, repeatedly, in the eurozone. After all, there’s not a terrific one-stop-shop replacement for US debt—lumping the US in with the global AAA sovereign debt market, America makes up about 58% of it. Germany has the next biggest chunk at 14%, then the UK at 11%. Most important, surprises (that are fundamental in nature) tend to be the most effective market movers—a power Fitch’s warning to downgrade the US, already much-discussed and widely known, seems to lack.