Nigel Sillis, Director of Research, Fixed Income and Currency Team, Baring Asset Management in London

Comment: US AAA credit rating is unsustainable

Despite the US edging closer to a bipartisan deal that would raise the country's borrowing limit, Nigel Sillis (pictured), Director of Research, Fixed Income and Currency Team at Baring Asset Management in London, still believes it's a case of 'when' rather than 'if' America's credit rating is downgraded…

In the US, details of a tentative bipartisan deal that would raise the US government’s borrowing limit started to emerge over the weekend. If Congress doesn’t approve the federal government’s request to raise the ceiling on the amount of money it can borrow, funding will run out in early August – on the 2nd according to the Treasury’s own forecasts.

The deal still has to be passed by both the Senate and the House of Representatives, but if we assume that it passes in the current form, then our analysis suggests that while the ratings agencies are likely to maintain the US government’s credit rating for the moment, attention is likely to turn to the implementation of the spending cuts – a projected USD2.8 billion over ten years – and particularly the second phase of cuts, which needs to be recommended by a special joint Congressional committee by November.

We still take the view that the AAA credit rating of the US is unsustainable in the medium to long term, and the question therefore becomes not if the US will be downgraded, but when.

To our mind, the response of foreign public-sector money to the loss of the US AAA rating is the most crucial unknown factor for financial markets and the path of the global economy. The extent to which foreign central banks and sovereign wealth funds buy US Treasuries to benefit from the security of a US Government promise is unknown. The alternative explanation – that they purchase them to recycle current account surpluses back into their principal client as a form of vendor finance and exchange-rate targeting – appears persuasive to us. If our understanding is correct, there will be no earth-shattering market impact from a downgrade to AA.

To ignore the seismic policy developments that are dominating markets would be a dereliction of duty, but the dangers of being caught in the latest headline are meaningful. And so we focus on whether our estimates of risk premia available in the US government bond market are sufficient to account for all of these risks.

The Treasury market is biased towards the third of our scenarios (Confluence of shocks – a global slowdown), having given up most of the inflation risk premium they had discounted. However, the uncertainty associated with the future path of inflation means that this scenario is not fully discounted. With policy still broadly accommodative globally and the amount of noise in various output time series, a rise in bond yields remains a material risk to markets.

As such, where we can be, we are generally underweight US Treasuries across fixed income portfolios at Barings. Equally, however, we have not reduced exposure specifically in response to the debates around the US debt ceiling. A credit downgrade for the US government is a real possibility, but unlikely to prove a shock to market participants.

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