America loses its AAA again. Does it matter?

Fitch Ratings cut the United States from AAA to AA+ on 1 August, an unwelcome reminder of the fiscal arithmetic. Administration officials were indignant, as expected, and share prices wobbled briefly. Nobody seriously thinks the US government will default on debts it can pay in its own currency.

Twelve years after S&P

This is the second time America has lost a top rating. Standard & Poor's cut it to AA+ in August 2011, after a debt-ceiling fight that brought the Treasury within days of running out of room to borrow. Moody's still rates the country at its top grade, so Washington now holds the highest rating from only one of the three big agencies. Fitch had warned in May, during this year's own debt-ceiling standoff, that a downgrade was possible, and it placed the rating on watch then.

That standoff ended in early June with a deal that suspended the ceiling until 2025 and imposed modest caps on discretionary spending. It avoided default but did nothing to change the long-run trajectory of borrowing. Fitch waited until the drama was over and then acted anyway, which makes the point that its concern was never really the ceiling itself.

Marked down for bad governance

Fitch's complaint was about how America is governed, and about the drift in its public finances, more than about its ability to pay. Repeated debt-ceiling standoffs and unfunded fiscal expansions have worn down Washington's credibility, and there is still no plausible medium-term plan to shrink the deficit. The agency simply said out loud what the bond market already prices, that American public finances are on an unsustainable path.

The numbers support it. The Congressional Budget Office projects that federal debt held by the public, already close to the size of the economy, will reach 181 per cent of GDP by 2053 under current law. Deficits are running far above what is normal outside recessions or wars, and higher interest rates are raising the cost of servicing the stock of debt. On the day before the downgrade, the Treasury said it expected to borrow about $1trn in the July-to-September quarter alone, more than markets had anticipated.

What happened last time

The 2011 precedent is a useful guide, though not in the way the downgrade's critics expected. After S&P acted, stock markets fell sharply, but Treasury yields went down rather than up, as investors worried about the euro-area crisis sought safety in the very bonds that had just been downgraded. The dollar held its ground. That episode is the best evidence that ratings on the world's reserve currency issuer matter less than ratings on anyone else.

It also shows that timing is everything. In 2011 the global backdrop sent money into Treasuries. Today the Fed is shrinking its holdings, foreign central banks are not adding much, and the Treasury is issuing heavily. A downgrade that lands in a market already short of natural buyers is more likely to nudge yields up than one that lands in a panic elsewhere.

Where the discount shows up

The cost of weaker governance does not appear as default risk, since the Fed can always create the dollars to pay. It appears instead in the term premium, the extra yield investors demand for holding long-dated bonds rather than rolling over short-term bills. That premium rises when investors doubt that fiscal policy will be managed predictably, because unpredictable deficits mean unpredictable supply and a higher risk that inflation will be tolerated to ease the debt burden.

Each basis point of extra yield across a debt stock of this size adds up to real money for taxpayers over time. It also feeds through to mortgages, corporate bonds and other borrowing priced off Treasuries, so households and companies pay part of the governance discount too.

Forced selling is not the channel either. Investment mandates that refer to ratings almost always treat Treasuries as a category of their own, and since the Dodd-Frank Act of 2010 American regulators have been required to remove references to agency ratings from their rules. Fund managers who had to decide what a split rating meant for their guidelines did that work in 2011. Whatever pressure comes from this downgrade will therefore arrive slowly, through the price of new issuance, rather than as a burst of sales by holders obliged to dump bonds.

Winners and losers

The losers are American taxpayers, who will fund higher interest bills, and borrowers whose rates are benchmarked to Treasuries. The few sovereigns that retain triple-A ratings from all three agencies, such as Germany, Switzerland and Australia, gain a modest reputational edge, though none has a bond market large enough to replace Treasuries. Holders of existing long-dated Treasuries face mark-to-market losses if the term premium rises.

Treasury Secretary Janet Yellen criticised the decision as arbitrary and based on outdated data. She has a point about timing: little in the fiscal outlook changed on 1 August. But ratings agencies are slow by design, and their downgrades tend to confirm trends rather than reveal them.

The case that it changes nothing

The strongest counterargument is that the Treasury market is too deep, too liquid and too central to the global financial system for a rating to matter. Banks hold Treasuries as their safest asset under regulatory rules that do not depend on agency ratings, clearing houses accept them as collateral, and foreign central banks have no comparable alternative. On that view the downgrade is noise.

That is right as far as demand for Treasuries in a crisis goes. It is less persuasive about the price investors demand in normal times, when the question is not whether to hold Treasuries but at what yield. The next tests are near: government funding runs out at the end of September, and a shutdown fight would reinforce Fitch's governance argument. The loss of a second AAA rating will not set off a buyers' strike in Treasuries. It does formalise a governance discount, and America will probably pay a little more to borrow for years to come, most visibly in long-dated yields that stay higher than the Fed's policy path alone would justify.