The decision by Standard & Poor's to affirm the U.S.'s short-term rating at the top A-1+ level even as it cut the long-term grade from AAA may help to stabilize money markets, according to strategists and economists.
The move means money market funds won't be forced to sell Treasuries, said Mansoor Mohi-uddin, the Singapore-based chief currency strategist at UBS AG. The "impact" on money funds "appears to be limited," Philip Marey, the senior U.S. strategist at Rabobank Groep in Utrecht, Netherlands, wrote in a report to clients.
While S&P has warned since mid-July that a downgrade was likely, measures of distress in short-term funding markets have declined since then, signaling that traders expect little disruption. Two-year interest-rate swap spreads are trading at about one-third of the levels reached in May 2010 as the extent of Greece's fiscal troubles came to light and one quarter of that in the weeks before Lehman Brothers Holdings Inc. collapsed in September 2008.
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"The long-term downgrade shows that this is much more of a symbolic downgrade, and a warning that the U.S. needs to get its house in order, but by leaving the short-term rating unchanged, that is an important message because of the money-market implications," said George Goncalves, head of interest rate strategy at Nomura Holdings Inc., one of 20 primary dealers that trade directly with the Federal Reserve.
General-Collateral Rates
Treasuries are pledged as collateral by borrowers in the $4 trillion repurchase market, where banks, companies and investors come together for short-term funding, Marey said. The concern is that lenders may demand a higher amount of Treasuries as collateral for the same amount of cash.
Overnight general-collateral Treasury repurchase-agreement rates averaged 0.2 percent on Aug. 5, according to ICAP Plc, the world's largest inter-dealer broker, down from 0.32 percent on Aug. 1 and versus the 0.13 percent level in mid-July when S&P warned that a downgrade may be coming. The average this year is 0.102 percent.
S&P lowered the U.S. long-term rating one level to AA+ after the markets closed on Aug. 5 while keeping the outlook at "negative" as it becomes less confident Congress will end Bush-era tax cuts or tackle entitlements. The rating may be reduced to AA within two years if spending reductions are lower than agreed to, interest rates rise or "new fiscal pressures" result in higher general government debt, the New York-based firm said.
'Falls Short'
"The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics," S&P said in a report.
Moody's Investors Service and Fitch Ratings affirmed their AAA credit ratings on Aug. 2, the day President Barack Obama signed a bill that ended the $14.3 trillion debt-ceiling impasse that pushed the Treasury to the edge of default. Moody's and Fitch also said that downgrades were possible if lawmakers fail to enact debt reduction measures and the economy weakens.
In the weeks before S&P's move, Wall Street's fixed-income trading units prepared for a potential U.S. downgrade, minimizing their inventory positions, Brad Hintz, a Sanford C. Bernstein & Co. analyst, wrote in an Aug. 1 note to clients.
Revenue Crimp
New York-based Goldman Sachs Group Inc. and Morgan Stanley's fixed-income trading revenue may be crimped anyway, if a downgrade results in changing rates, currency-market volatility and widening credit spreads, Hintz wrote.
At Goldman Sachs, senior executives viewed a U.S. downgrade as "manageable," Citigroup Inc. analysts led by Keith Horowitz wrote in a July 28 note to investors. The analysts said they met with Goldman Sachs Chief Financial Officer David A. Viniar, Co- Head of Securities Harvey M. Schwartz, and Co-Head of Investment Banking David M. Solomon.
"Management noted that they have run through various scenarios," the Citigroup analysts wrote. Still, "there is always the possibility of more severe knock-on effects."
A gauge of fear in the short-term debt markets has been relatively muted even as the prospect of a downgrade of the U.S. rose in recent weeks.
The difference, or spread, between the two-year swap rate and the comparable-maturity Treasury note yield was at 27 basis points, or 0.27 percentage point, today in New York. The measure has ranged during the past three months from 15.5 on May 12 to 33.81 on July 12. The three-month Libor rate rose to 0.275 percent, the highest since April, according to Bloomberg data.
Swap Spreads
Current spread levels compare with intra-day highs of 64.21 in May 2010 as the extent of Greece's fiscal crisis came to light, and 167.25 in October 2008 following the collapse of Lehman Brothers as credit markets froze. The inability to obtain short-term funding is one of the reasons Lehman filed for bankruptcy, and why Bear Stearns Cos. almost failed before being sold to JPMorgan Chase & Co. earlier in 2008.
"Many repo agreements stipulate triple-A collateral and there could be some confusion to be sorted out," Chris Low, the chief economist at FTN Financial in New York, said in a note to clients. "Because two of the three ratings agencies confirmed the triple-A rating, however, the contracts should still be valid even with Treasury and Agency collateral."
Concern that Europe's fiscal crisis is worsening may weigh on short-term funding markets as speculation rises that banks may need to take bigger losses on their sovereign-debt holdings as yields on Italian and Spanish bonds rise to euro-era records relative to bunds.
Europe Concern
"We would not be surprised if the downgrade increases the sense of panic in European credit markets," Low said in the note.
S&P's downgrade won't affect the capital positions of U.S. banks, regulators said. Banks, which hold Treasuries as a form of capital, won't need to build larger cushions to protect against possible losses, a group of banking regulators, including the Fed and the Federal Deposit Insurance Corp., said in a statement in Washington late on Aug. 5.
"For risk-based capital purposes, the risk weights for Treasury securities and other securities issued or guaranteed by the U.S. government, government agencies and government- sponsored enterprises will not change," the regulators said.
Fed Watch
One of the missions of the Fed is to ensure the safety and soundness of the U.S. banking system. During the 2008 financial crisis, the Fed required the biggest banks to undergo "stress tests" and ordered some of them, including Citigroup Inc. and Bank of America Corp., to enlarge their capital buffers.
Lending through the discount window surged to a high of $110 billion a day during the height of the financial crisis in the fall of 2008 following the collapse of Lehman. At the time, banks turned to the Fed as a lender of last resort because their sources of credit were frozen. Fed lending through the discount window was down to $10 million for the week ending Aug. 3.
The Fed official also said that S&P's decision would have no implications on its ability to influence interest rates through open-market operations. The Fed in June completed a $600 billion Treasury bond-purchase program aimed at bolstering the economy.
"In our view, this ratings action should not have a material impact on short-term markets," said Alex Roever, the head of short-term fixed-income strategy JPMorgan Chase, ranked the No. 1 debt research firm by Institutional Investor magazine.
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