In his address to the nation on July 25, President Barack Obama warned with certainty that if the credit rating of the United States is downgraded by the rating agencies, "interest rates will skyrocket on credit cards, on mortgages and on car loans, which amounts to a huge tax hike on the American people."
The president's statement was likely prompted by rating agency Standard & Poor's pronouncement a week earlier that there was a 50 percent probability it would downgrade the U.S. credit rating in the next 90 days. The probability of a downgrade was increased from 33 percent just a few months prior.
The market determines interest rates, not the rating agencies.
The president's statement seemed to indicate that with a downgrade, rising rates are an absolute certainty, and likely many Americans believed that to be true.
However, a downgrade does not necessarily translate into an automatic or even an eventual increase in the cost of borrowing.
The market apparently wasn't troubled or surprised by either warning from S&P.
Since the first warning in mid-April, the yield in the 10-year Treasury has fallen about half a percent; the opposite direction that you would expect from a security that is increasing in risk.
Rating agencies have earned a reputation for being less than helpful due to their inability to be forward-looking.
All three major rating agencies rated AIG and Lehman Brothers as investment grade credits just prior to their collapse. Rating agencies were also notorious for maintaining positive ratings on securities backed by subprime mortgages which eventually cratered, precipitating the 2008 credit crisis.
In each scenario, rating agencies downgraded the securities after the market had adjusted the price to reflect the true value. The damage had already been done. The crises was not averted.
For investors who own debt issued by lesser-known municipalities, credit ratings can be a helpful starting point in evaluating a security's risk. But for corporate and sovereign issuers that are tracked by millions around the world, how much value do the credit rating agencies add; especially when addressing the solvency of the government overseeing the largest economy in the world?
Renowned investor Jim Rogers asserted in the Wall Street Journal that the U.S. has already lost its AAA status. Rogers said in a July 25th article that, "It's only S&P and Moody's that haven't figured out what is going on. The investment world knows that the U.S. is not AAA."
Each agency has its own method of assigning credit ratings. Standard & Poor's assigns an AAA rating to the best credit. Creditors in this category are considered to have "extremely strong" capacity to meet financial commitments. One notch down is AA+, for which the "extremely strong" language is relaxed to "very strong."
The difference in wording is negligible, and if the U.S. is downgraded, it is likely to have more of an effect on national pride than anything else.
A report by BMO Capital Markets issued July 25 recalls that Canada, Japan and Australia have lost their AAA rating in the past and were only marginally impacted.
Canada and Australia were able to regain their AAA rating after several years of fiscal discipline. The report cites that Japan's interest rates, after having been downgraded in 2001, were fairly stable. Ten years later, Japan's 10-year yield remains close to 1 percent, with its currency near the strongest levels of the decade. (Yields were 1.2 percent before the earthquake in March).
Others believe a downgrade will raise borrowing costs. Morningstar published a report in late July stating they expect long-term interest rates to increase 25-50 basis points in the event of a downgrade.
Their analysts expect that a downgrade of the U.S. also will result in downgrades in other sectors of the U.S. government, which include Fannie Mac, Freddie Mac, Federal Home Loan Banks and Federal Farm Credit System Banks. Morningstar expects debt costs to increase 30 to 40 basis points for these entities.
There are many factors that tend to drive interest rates; including Fed policy, economic growth, and the relative attractiveness of Treasuries over other investments.
In times of economic uncertainty there is a "flight to quality", which creates an increase in the demand for Treasuries. When demand increases, price increases, and yields fall.
These dynamics are put into motion by market participants. The opinions of the credit rating agencies likely play a small role, if any, in determining the relative attractiveness of U.S. Treasuries.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken, CFA, is vice president of investments with DeMoss Capital -- demosscapital.com. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfreepress.com.