With Fitch Rating's admonishment last week it would put U.S. debt on watch for a downgrade in early August, all three of the major rating agencies now have issued unprecedented warnings about the U.S. debt crisis, putting the country’s AAA credit rating in danger. But so far, Treasury investors have reacted with a collective yawn.
On Monday, the US 10-year Treasury bond was still at a yield of 2.99%.
Compare this to the reaction to the almost simultaneous downgrade of Greek debt by Standard & Poor's, which knocked Greece’s sovereign debt rating down to CCC. In response, the Euro fell, oil prices fell, equities markets fell and the price of insuring Greek bonds rose by 33 basis points.
Why the benign response from U.S. Treasury investors?
“Treasuries remain the deepest, most liquid asset in the world, and it makes up an important part of many portfolios,” says Jeffrey Cleveland, senior economist at money manager Payden & Rygel. “So in a sense the U.S., as issuer of Treasuries, is ‘too big to fail.’”
But he hastens to add, “At least today. It’s not to say that investors don’t see mounting U.S. debt as a longer-term issue. But I think at least with regard to the issue of raising the debt ceiling, people thing that will be resolved.”
Axel Merk, manager of Merk Funds and chief investment officer of Merk Investments, offers another perspective. He suggests that the rating agencies may have been jumping the gun.
“After being too late in addressing the housing bubble, the rating agencies have decided they won’t be late in downgrading anyone anymore,” he said. “But the U.S. can always print money, so the country will not default,”
That said, he adds, “As to the question of whether the U.S. is ‘too big to fail,’ I would say anybody who thinks it can’t happen here is likely to be surprised.”
Merk suggests one reason that Treasury yields remain relatively low despite concerns about the national debt, and despite the rating agency warnings, is that “Treasuries are so scarce.”
He explains, “The whole world is buying Treasuries in a time of uncertainty because they are so liquid.”
The risk, he said, is that at some point, nations and large banks could turn to other nation’s sovereign bonds, learn to deal with the reduced liquidity of those instruments, “and then they might be less willing to come back to U.S. Treasuries.”
For now, though, he says investors see the issue of the U.S. debt ceiling as “simply a political game of chicken,” and don’t take it seriously.
David Wyss, who recently retired as a chief economist at Standard & Poor's, said one reason investor action has been so calm in the wake of the three agency downgrade warnings is that a downgrade could have little impact on rates.
"The U.S. situation is most analogous to Japan 20 years ago," he explained. "We downgraded Japan as well, but bond yields didn't rise. As long as a country can issue debt in its own currency, the threat of default is remote because it is cheaper to print money than default."
Wyss added that the dollar still "looks like the healthiest horse in the glue factor" and "that makes Treasuries a safe bet in a world where there is more money looking for investments than there are investments."
At least one expert, Robert Tipp, chief investment strategist with Prudential Fixed Income, argues that it’s not that investors aren’t alarmed by the rating warnings by the three agencies, but that they were ahead of the agencies in already pricing in their concerns.
“This has been going on for at least three years,” he said, “and that’s why the 10-year Treasury is at 3% now.” He notes that German 10-year debt is also at 3%, but that German money market rates are at 1.25%, while in the U.S., money market rates are close to zero.
“So the premium on debt vs. cash in Germany is about 1.75%, while in the U.S., it’s close to 3%,” he said.
“I think Treasury investors are investing with their eyes open,” he added. "That’s not to say that a default has been priced in.”
If there were to be an impasse on raising the deficit ceiling this August, and there were a technical default he warns there "could be some fireworks in the Treasury market, no question. Hopefully, saner heads will prevail.”