Downgrade of U.S. Sovereign Rating Possible: How Will Markets React?

There is no political consensus as yet over raising the debt limit of the largest debtor nation. The White House and the Republican leadership of the Congress are in a stalemate over the question of raising the debt limit from $14.3 trillion.

As the Aug. 2 deadline approaches, markets are fretting over the prospect of a Treasury default, and at least one global rating agency has suggested a downgrade of the U.S. sovereign rating is around the corner.

"History shows that even when the decision to raise the debt ceiling goes down to the wire, it does not lead to a default or a change in the perception that the U.S. is the gold standard against which to benchmark other debt. This time around the stakes are higher," Standard Chartered bank analysts said in a note to clients.

Among the ratings companies, the Standard & Poor's is showing the greatest concern about the lack of a long-term plan to restore fiscal balance in the U.S., according to the analysts. Fitch toes a rather dovish line and has yet to alter its outlook for U.S. ratings while Moody’s has suggested that the U.S. eliminate its debt ceiling to lower uncertainty among bondholders.

Irrespective of whether the debt ceiling is raised before Aug. 2, there is considerable chance of a ratings downgrade, according to the analysts. This is because S&P insists that the debt-ceiling hike should also incorporate an agreement on reducing deficits to the tune of $4 trillion in the next decade. Chances of this happening are slim.

"This is what S&P sees as the required amount to prevent the total government debt-to-GDP ratio from rising. Therefore, a debt-ceiling deal with deficit cuts falling short of this could mean a downgrade by at least one of the three key rating agencies," it said.

As well as placing the U.S. sovereign-debt rating on negative watch, S&P has put AAA-rated clearing houses Fixed Income Clearing Corporation, National Securities Clearing Corporation, Options Clearing Corporation and CSD Depository Trust & Clearing Corporation on negative watch, the Standard Chartered bank report says. Those financial institutions with a direct reliance on the government, such as Fannie Mae and Freddie Mac, are also on negative credit watch.

To gauge the possible market reaction to the scenario, Standard Chartered asked a selection of market participants what would be their response if UST lost AAA status. They were given four choices, (a) Sell immediately, (b) Change investment restrictions to permit ownership at lowered ratings, (c) Press for industry-wide regulatory relief, permitting continued ownership and (d) None of the above.

To the first option, the majority of participants said that there are few realistic alternatives to the U.S. government bond market. They said there is no other market with as much depth or liquidity in the world.

More importantly, the majority opinion was that the downgrade only by S&P wouldn't deal a big blow. If it is only S&P, it is unlikely that many funds will be forced to offload those securities, they said. What Moody's does will be closely watched as well.

The majority pointed out that option B, changing investment restrictions to permit ownership at lowered ratings would be the preferred option. This is because there isn't that much AAA investment out there as an alternative.

However, the majority view was that it is highly unlikely that a UST downgrade will occur. However, if a downgrade does occur, there may be a knee-jerk reaction among the real-money investment community, it says.