Sovereign credit analysts have a great life. They’re paid to fly around the world, rub shoulders with policy movers and shakers, build glorious Excel workbooks, and dispense important opinions.
Moreover, these opinions don’t need to change very often. It’s probably preferable if they don’t. In the case of the United States government there have been only two full-on rating actions from the three main agencies in the past century. (We’re not counting changes in rating outlook.)
But with US debt metrics having deteriorated meaningfully, it might seem reasonable to expect the agencies to be the bearer of bad news before too long.
We wrote to Moody’s and S&P earlier in the week to ask them about any forthcoming rating actions. And within 24 hours both agencies came out with rating actions. Did they downgrade? Readers, they did not.
What supports these super-high ratings? Let’s take a look.
First up, it’s not some rosy projection for debt-to-GDP:
Back in 2011 — when S&P downgraded the sovereign to AA+ — the CBO projected federal debt held by the public would rise to 80 per cent of GDP by 2030 (pink line). Things turned out somewhat worse, and the bipartisan federal agency’s latest long-term fiscal forecast (red line) is now for publicly held debt to hit 109 per cent of GDP by 2030.
Moreover, the CBO forecast is predicated on current law — so doesn’t take into account the prospect of Trump tax cuts becoming permanent. Furthermore, it has federal revenues ticking persistently higher as a share of GDP. In reality, revenues have undershot forecasts. Maybe tariffs will fill the hole? It seems unlikely.
Of course, S&P’s own forecasts would’ve been more important to their analysis. Back in 2011, the rating agency projected net debt to rise to 78 per cent of GDP in ten years’ time. Under a downside scenario they mapped out, consistent with a further downgrade to ‘AA’, they projected net debt could reach 101 per cent of GDP. According to the CBO, this figure hit 102 per cent of GDP in 2021.
To be fair, debt-to-GDP is a silly metric of fiscal space. Moody’s reckons it’s heading to 130 per cent of GDP by 2035 (light blue dashed line) but this doesn’t get in the way of their AAA rating.
The real metric that we should be looking at, according to Moody’s, is debt service. As its analysts wrote in their 2023 rating report:
For a reserve currency country like the US, debt affordability — more than the debt burden — determines fiscal strength.
So maybe this is projected to improve? Nope.
For years, low bond yields, more than offset the fiscal costs of higher debt loads. Today’s higher bond yields change the picture. Again, we took CBO long-term forecasts to compare today’s projections (in red) to those made in yesteryear (with 2011 forecasts in pink), and added the forecasts contained in this week’s Moody’s AAA rating report:
Not a great picture. It almost seems as if trying to find some connection between debt metrics and the sovereign rating is a fool’s errand.
And — to be fair to the agencies — this is almost what they say too.
In its most recently published rating opinion, S&P assigned the government its second worst score for fiscal flexibility and performance, and its very worst score for debt burden. And according to Moody’s:
Even in a very positive and low probability economic and financial scenario, debt affordability remains materially weaker than for other AAA-rated and highly-rated sovereigns.
Outlining the main risk factors to their ratings, S&P starts not with fiscal factors, but instead say:
We could lower the rating over the next two to three years if unexpected negative political developments weigh on the strength of American institutions and the effectiveness of long-term policymaking, or jeopardize the dollar’s status as the world’s leading reserve currency.
While Moody’s writes that:
As a result of continued fiscal weakening, the US’ extraordinary economic strength and the unique and central roles of the dollar and Treasury bond market in global finance now play an even more important role in supporting the sovereign’s AAA credit profile.
So America’s top ratings really rest on effective policymaking, maintaining the strength of its institutions, and the continuing central role of the US dollar. Gulp.
It looks like the kind of coercive debt swap outlined in a paper authored by Stephen Miran, now Chair of the President’s Council of Economic Advisors, might not be understood as a credit-positive event.
Pedants may complain that the notion of a sovereign’s local currency credit rating being anything less than perfect is a nonsense. After all, it’s hard to run out of tokens that you can literally magic out of the air. But local currency defaults do happen pretty regularly.
Still, the difference in default probabilities associated with the various different highest credit ratings is angels-on-a-pinhead stuff. And that’s the job of a rating analyst — provide an assessment as to whether the chances of this happening over the next five years might be the kind of 0.0 per cent incidence of default attached to a AAA rating, or a 0.1 per cent chance that might be attached to a AA rating.
Would anyone really care if the US slipped a notch or three? Maybe not. Technically it could matter in terms of haircuts some people might apply bilaterally on treasury collateral. But the notion that either the Fed nor any large US clearing house would increase haircuts on Treasury collateral in the event of a downgrade — causing really financial plumbing mayhem — is unthinkable.
However, despite not arguably mattering, when S&P last downgraded the United States in August 2011 it prompted the worst single day fall in US stock prices since the (admittedly then recent) global financial crisis, made the then US Treasury Secretary Tim Geithner throw a bit of a public wobbly, and saw filmmaker Michael Moore calling on Obama to arrest the firm’s CEO. Someone hired a plane to fly past their rating agency’s offices dragging a banner proclaiming that they should all be fired, and a bunch of local governments terminated their business with the firm.
Meanwhile, and apparently unrelatedly, the Justice Department launched an investigation into the firm. Within a few weeks CEO Deven Sharma had left the company. When things moved from being just an investigation to an actual $5bn federal lawsuit for allegedly misleading banks about the credibility of its ratings before the 2008 financial crisis, S&P called this direct retaliation for their downgrade.
Still, as far as flouncing goes, Americans don’t hold a candle to the Italians.
Following Italy’s rating downgrades in 2011, prosecutors launched a criminal investigation against all three agencies which culminated in charges being filed against seven individuals at S&P and Fitch. The individual analysts faced jail sentences of 2-3yr and fines of up to €500k. Ultimately it took almost five years before an Italian court to acquit them of the charges.
We got in touch with one of the seven — David Riley, who was Fitch’s head of sovereign ratings and lead analyst on the 2011 Italian downgrade — to ask how it felt being on the wrong end of a large pointy stick being wielded by a disgruntled state. He told us that:
Being targeted by the state apparatus, even when wholly unfounded, is deeply uncomfortable. It is financially costly, your reputation is under attack and your liberty is potentially at risk. Rating analysts are never going to win any popularity contest, but when you incur the wrath of the state, criticism by market participants of how you are doing your job pales into insignificance.
Quite.
Rating agencies need sometimes to be the bearer of bad news. This week was not that week for the US.
While we’re sure that members of the Trump administration would react with maturity and solemnity to any downgrade, we can also see that being lead sovereign analyst with your name on the rating opinion might not be for the faint-hearted.
