The Anniversary of the S&P Downgrade – Have we Learned Anything?

It’s now been one year since Standard and Poors downgraded the debt of the USA from AAA to AA+.  If you recall, many pundits were saying this would be an earth shattering event and that it was a sign of much bigger problems to come.  Some even said it could cause a Eurostyle debt spiral in the USA where bond vigilantes attack and yields surge causing a funding crisis and even a potential default.  But what’s actually happened?  As you can see in figure 1 below yields have actually continued to move substantially lower.  In fact, yields are a full 1% lower than the 2.6% yield that we saw before the downgrade.  In other words, the downgrade has had zero impact.

Some might still be wondering why this is?  The reason is simple.  There is no risk of the USA having a funding crisis since it can always procure funds via taxes and bond sales.  That’s right, the government has no solvency risk.  It has only an inflation risk.  As I recently described:

“The USA has an institutional arrangement in which it is a currency issuer. That is, while the Treasury is an operational currency user (meaning it must always have funds in its account at the Fed before it can spend those funds) it is always able to harness the banks to procure funds. This is achieved through bond auctions in which the dealers are required to bid. The NY Fed explains:

Primary dealers are also required to participate in all auctions of U.S. government debt and to make reasonable markets for the New York Fed when it transacts on behalf of its foreign official account-holders.

So there’s never a concern about auctions failing in the USA. That is, the Treasury is a currency user, but the government as a whole can be seen as a currency issuer by institutional design because of this implicit funding guarantee. “

But don’t take it from me.  Take it from the bond traders themselves who clearly view US Treasury bonds as being among the safest assets on the entire planet….Sadly, Wall Street seems to have learned from this and they continue to snatch up bonds clipping coupons and reaping the benefits.  Meanwhile, the rest of us are forced to listen endlessly about how the government is on the verge of its Greek moment so we perpetually worry about “paying off the national debt” as opposed to understanding the actual operational realities of our monetary system, the effects of the balance sheet recession and how we are monumentally wasting one of our most powerful economic tools – the very government we designed….

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • FrankH

    At least we’ve confirmed that the ratings agencies are worthless.

  • Bobbo

    We don’t need to worry about paying off the national debt because we are never going to even try. We are going to leave the national debt to the bagholders! That’s what debtors in easy money systems always do, and all the savers who are buying all of this debt are going to get slaughtered.

    Sure, U.S, debt is the safest asset in the world right now. But only if you define safe as having the assurance that you will get paid in nominal terms. But is U.S. debt a “safe” asset in real terms? ARe buyers of U.S. debt savvy investors who are happy to receive close to 0% return? Other than the Fed, financial institutions in need of Tier 1 capital to meet regulatory requirements, and short term traders who will hit the sell button at the first sign that the trend will reverse, who is buying?

    I agree that we should print, print, print and spend, spend, spend as long as we can keep this racket going. But it will come to an end, because nobody in their right mind believes that future generations are going to pay off this debt in real terms.

  • Johnny Evers

    Classic short-term trader thinking — if it hasn’t happened in a year, then it’s no big deal.
    And Bobbo is right — the people who believe in endless government debt won’t be holding any when the crisis comes.

  • John A

    Cullen is right, but not quite ..

    The truth is, the credit downgrade was largely RESPONSIBLE for the fall in yields (though Eurozone worries have undoubtedly contributed). Scott Grannis here predicted the consequences of the downgrade before it even occurred, and his prediction was correct. In order to keep the average credit quality of their portfolios at a certain level, portfolio managers were forced to buy *even more* treasuries once the downgrade occurred. Needless to say, more buying drove down yields. If we get another credit downgrade, yields will probably fall further. Or, if S&P upgrades US debt, treasuries will sell off as portfolio managers will be allowed to buy more risky assets, since their average portfolio quality will have suddenly gone up.

  • http://www.pragcap.com Cullen Roche

    It’s not about believing in endless govt debt. It’s about understanding when debt becomes a problem. And debt issued by a nation that is autonomous in its currency means that inflation is the potential worry from increasing debt. NOT SOLVENCY. That could happen, but let’s at least understand the dynamics that will lead to higher inflation….

  • Bobbo

    Cullen, I think we have long passed the point when inflation is the “potential” worry from increasing debt. I submit that inflation is the guaranteed outcome in this slow-to-no growth environment. That’s why I suggested we look at who the buyers really are and why they are buying. Is this really a market driven phenomenon driven by long term private investors with a 30 year investment horizon? No way!

  • http://www.pragcap.com Cullen Roche

    Bobbo,

    Can you explain your thesis there? Why do you believe we are in for a bout of high inflation? Thanks.

    Cullen

  • Bobbo

    Because I do not think investors are willing to accept 1.5% in real terms for 30 years. I do not know a single human being who thinks that is a likely outcome or a reasonably good deal based on the last 41 years of fiat monetary history.

    In addition, I do not see a return to long term real growth at historical rates, largely because of energy and resource limitations. Most importantly, I think market psychology will demand higher inflation because this is the only way to deal with the current entitlements structure and pension obligations. The only politically acceptable and economically realistic way out of this mess is through higher inflation. Crisis fatigue is beginning to set in. No way can the investing public endure another 30 years of this.

  • Pierce Inverarity

    But where’s your causation? Typically high inflation (not to be confused with hyperinflation) is a actually a result of high growth.

  • Bobbo

    The causation can be a sudden loss of confidence (hyperinflation), or a increase in base money supply as a percentage of bank assets (which, as an alternative to growth, will operate as the kindling for increased velocity and higher inflation). I cannot say which outcome will actually happen. What I can say with virtual certainty based purely on my read of market psychology is that we cannot and will not maintain the current course for the next 30 years. Does anyone in his right mind disagree with that?^^

  • Pierce Inverarity

    Seems like you’re operating on the old “money multiplier” model of banking. This has been proven incorrect. Even the Fed has admitted as much.

  • Johnny Evers

    We’ve had war-time inflation (after WW1 and WW2); we’ve had guns n’ butter inflation (Vietnam War and Great Society), we’ve had stagflation infaltion (from 1970 to 1982 inflation was 7, 8, 9 percent, even higher some years) we had inflation 1990 and 1991 (not sure what caused that) and we had eight months of 4 and 5 pct inflation in 2008 right before the crash (warning sign, perhaps), and we’ve got inflation now if you count health care, education and taxes.)
    That’s a lot of inflationary periods, for a variety of reasons. Perhaps one main reason is a sudden expansion of federal spending. So I think the fairer question is: What do MMR proponents believe will happen when we have our next round of inflation?

  • Bobbo

    I think you focus too much on the causation question. The bottom line is that TPTB are going to demand inflation as the political “solution” and they are going to bring it about one way or another. Can you really imagine maintaining the current “crisis mode” for the next 30 years?

  • In Accounting

    bobbo, isnt that what japan has done though?

  • Johnny Evers

    Bobbo: I think inflating our way out of excess debt might be the favored solution by some policy makers and pundits, but it would be a very strange form of inflation, imo.
    The Fed wants to keep interest rates low to keep borrowing costs of the growing debt low; wages can’t rise because of the pool of unskilled, unemployed workers competing against factory workers elsewhere; federal spending must rise because of entitlements and the aging population.
    We might get an amped-up version of today’s economy — low rates, stagnant wages, skyrocketing prices of goods and services, maybe shortages of goods as producers go on strike. If asset prices also rise, that would mollify the narrow class of Americans with ample investments, but enrage everyone else.
    You can’t really control inflation or know what form it will take.

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  • Bobbo

    In accounting, yes, good point. But Japan had a savings glut and a homogeneous society. The older middle class generation with all those savings did not mind the deflationary policy. I think the political situation in the U.S. is more volatile. And there is a risk even Japan will reach a tipping point before the end of its third lost decade. The pension funds are going to need to start selling a lot of those bonds to make payments to the older generation. The Japanese government will take an ever-increasing share of the bond market. Do you really think those bonds are going to be paid off in real terms?

  • Bond Vigilante

    If the US has no risk of experiencing a funding crisis then why are foreigners not adding to their T-bond holdings in spite of a US Trade Deficit of about $ 600 bln. ?

    http://traderdannorcini.blogspot.nl/2012/04/pre-easter-weekend-comments.html
    http://www.crgraphs.com/2011/09/trade-graphs.html

  • Bond Vigilante

    Yes, the politicians would like to inflate the debt away. And that’s why they hate Deflation so much. Because then they have pay off the debt with dollars that are worth more instead of less.

  • http://www.pragcap.com Cullen Roche

    Your own chart proves your comment wrong….This looks like a nice steady uptrend to me….

    http://3.bp.blogspot.com/-c16lIBAW704/T38ZYL9oxVI/AAAAAAAABR8/2Ybc-KNp7qw/s1600/treas.PNG

  • Bond Vigilante

    1. Well, then that (presumed) uptrend still has to (convincingly) take out the previous high(s).
    2. Not buying T-bonds means a downward pressure on the USD. But the USD went – on average – up since september 2011. Foreign central banks seem to have taken the advantage of a strengthing USD to not adding T-bonds. Those darn foreign currency manipulators, right ?

    Look at the foreign custodial holdings of Agency paper. They ditched that paper starting in june/july 2008. Right at the moment when the USD went up. Otherwise the USD would have gone up MORE in the second half of 2008.

    Remember, Europe and/or China going down doesn’t need have to have mortal consequences for the US. But when/if the US goes “down the drain” then it WILL take down Europe and China as well. Remember the piece of Brett Fiebig ? The USD is the senior currency and therefore a US default has MASSIVE implications for the rest of the world. US T-bonds/bills constitute the reserves of foreign central banks.

  • puzzled

    So Grannis thinks that a decline in a credit rating (supposedly equal to an increase in risk) results in a decline in yield? Using that logic Greece should have yields approaching zero.