Deal or no deal, has the damage been done?

Deal or no deal, has the damage been done?

The financial markets are on edge as the United States once again comes to the brink of defaulting on its debt. Many commentators have claimed that it is impossible to predict the scale of the fallout if Congress fails to reach a deal, and hence are unsure of how to act. But Central Banks may already be adjusting their reserve holdings as the credit quality of the country deteriorates.

Central Banks have strict mandates about the quality of the assets that are held as part of their reserve, and the ratings agencies play an important role in assessing the quality of these assets.

Bonds issued by the United States Government feature heavily in the holdings of Central Banks because of the high rating that is applied to their credit quality. Prior to 2011, each of the agencies had a ‘AAA’ rating on debt issued by the United States Government, which was the highest possible quality. But in August of 2011, S&P lowered the rating by one notch from ‘AAA’ to ‘AA+’. It is interesting to read the commentary from this announcement (keep in mind this was two years ago):

“We [S&P] have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics any time soon”.

At the time, the other two major ratings agencies, Moody’s and Fitch, did not follow suit with the downgrade. Because the majority of agencies considered that the Government deserved the highest possible credit rating, S&P’s actions may not have had a considerable impact on the composition of Central Bank reserves.

But Fitch has just placed the United States’ rating on ‘negative watch’, stating that, “Although Fitch continues to believe that the debt ceiling will be raised soon, the political brinkmanship and reduced financing flexibility could increase the risk of a US default”.

A ‘negative watch’ indicates that there is a reasonable likelihood of a downgrade in the short term, or typically within 12 months. While the US is still rated ‘AAA’, it is likely that Central Banks would consider this negative watch to be just as critical as a downgrade. Now that two of the three ratings agencies have effective downgrades on US bonds, this may prompt the Central Banks to modify their reserve holdings, particularly since the debt may no longer be treated as ‘risk-free’. As such, it is likely that Central Banks may sell a portion of their US bonds as their reserves are adjusted in accordance with the heightened level of risk.

So while Congress may once again sign another ‘eleventh hour’ deal to raise the debt ceiling and avoid a default, the damage to financial markets is already being done.