Perspectives
July 2011
Current Economic Events
US Treasury Downgrade Likely
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Michael Lillard
Chief Investment Officer
Prudential Fixed Income
With the August 2 U.S. debt ceiling deadline approaching, the prospects of a
significant deal being reached —e.g. $4 trillion or more in deficit reduction over
the next ten years —is, in our view, appearing less likely. We believe the
likelihood that the U.S. Treasury will be downgraded to AA has risen
significantly. In the event that Washington does not reach a deal prior to hitting
the debt ceiling in August, the U.S. Government would then be expected to cut
non-debt-related expenditures sharply, but we think the likelihood that it would
actually default on any debt payments is extremely low.
The US Debt Ceiling Debate
The debate has largely centered on the size and composition of budget deficit
reductions over the medium term (generally a 10-year horizon), to accompany any
increase in the debt ceiling, with the magnitude of the debt ceiling relief tied to the
size of these reductions. At this point, several competing plans have been put forth,
calling for varying degrees of fiscal consolidation, and hence varying magnitudes of
immediate increases in the debt ceiling. Suggestions have ranged from short-term
fixes of several hundred billion dollars to long-run fixes of as much as $9 trillion.
Thus, some of the plans currently being discussed imply that the debt ceiling would
be lifted by enough to cover the financing of only several more months of budget
deficits; others imply a lifting of the debt ceiling by enough to cover budget deficits
into 2013 or beyond. Given the difficult politics involved and with negotiations now
down to the wire, calls for deficit reductions in the range of $1 trillion to $3 trillion over
the next ten years appear to now be getting the most focus, in some cases with the
caveat that detailed agreements on at least part of the packages be negotiated in at
least a two stage process.
For more information contact:
AA Downgrade Likely—But Timing Uncertain
Jim Fernandez
Prudential Investment
Management
2 Gateway Center
4th Floor
Newark, NJ 07102-5096
973.802.6791
While the ultimate outcome of the negotiations is highly uncertain at this point, one
thing is known: Credit rating agencies have put the U.S. on notice for a possible
downgrade. S&P, for example, has cited $4 trillion in credible deficit reduction over
the next ten years or so as a threshold for maintaining a AAA rating on the U.S. But
with negotiations now appearing to center on packages well shy of $4 trillion, the
likelihood of the U.S. being downgraded to AA has risen significantly.
[email protected]
The reality is that this year’s projected budget deficit of 9% of GDP, despite the
economy beginning its third year of recovery, is a tough situation for the U.S. to be in.
Prudential Fixed Income
Perspectives July 2011
Page 2
The persistently weak recovery—not a surprising turn of events given ongoing deleveraging in the private
sector in the aftermath of the financial crisis—is a key factor in delaying an improvement in the U.S.
government’s deficit and debt trajectories. With federal debt held by the public (i.e. net debt) projected to
reach over 70% of GDP this year, up from 36% in 2007, the U.S.’ credit profile is looking weak relative to
the small pool of other AAA-rated countries. Unless there is a significant turn of events in Washington, it
appears unlikely the overall package will be significant enough to put the U.S. government’s debt
trajectory on a stable path. Without such a package, the U.S.’s fiscal position will likely continue to
deteriorate. And the smaller the package, the faster the rating agencies are likely to downgrade the U.S.
A downgrade of the U.S. sovereign rating would likely affect not only Treasury securities, but also the
ratings of issuers that either derive credit support from the government or are highly tied to the U.S.
Government in other ways. This could include agency debt and agency-guaranteed MBS, as well as
government-guaranteed student loans, and the municipal debt of several AAA-rated states.
Potential Impact on Markets of a U.S. Credit Downgrade
With the likelihood of the U.S. losing its AAA rating now rising, markets appear to have begun pricing in
the possibility. If a downgrade were to actually occur, however, we think it is unclear what impact this
would ultimately have on the level of interest rates. While a downgrade might be expected to cause a
Treasury sell-off, the immediate negative impact on consumer and business sentiment would likely
dampen economic activity, which could cause interest rates to fall. On the other hand, spread sectors
would generally be expected to outperform Treasuries, given the deterioration in Treasury credit quality
as well as the persistently huge relative supply of Treasuries. We would also expect the U.S. dollar to
continue its downward trajectory in this case, as a downgrade would imply the U.S. Government’s budget
dynamics are continuing along an unsustainable path.
Probability of Missing a Debt Payment is Likely Extremely Low…However
In the unlikely event that even a small deal isn’t reached, we think the U.S. Government is still very
unlikely to actually miss a debt payment. The debt ceiling implies no net new borrowing, so roll-overs of
existing debt would still be feasible. Moreover, incoming tax revenues greatly exceed scheduled interest
payments and we expect the Treasury will make these payments a top priority. The U.S. Government
would therefore be forced into cutting non-interest expenditures sharply to levels consistent with tax
revenues less interest payments. Such a rapid fiscal contraction would be expected to hurt an already
weak economic recovery; the longer any stalemate on lifting the debt ceiling, the larger the likely negative
impact on the economy. Again, our base case scenario still assumes that the debt ceiling is ultimately
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lifted by the deadline. Further, we believe the widely cited August 2 date could be extended to midAugust due to higher than expected tax receipts.
Prudential Fixed Income
Perspectives July 2011
Page 3
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