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Wednesday, August 2, 2023


Yesterday’s Fitch downgrade of the United States launched the usual amount of silliness (my contribution above). Rating agency discussions are good way of distinguishing people who are familiar with the bond markets with those who are not. The following two things can be true at the same time.

  1. Credit ratings are a useful part of the credit market ecosystem.

  2. Credit ratings of floating currency sovereigns are silly.

Why? Credit rating agencies have large databases of conventional issuer defaults — corporations, sub-sovereigns, sovereigns borrowing in an external hard currency. They can then calibrate ratings against historical default rates. (Note that the structured products going into the GFC were novel — and thus the ratings based on wishful thinking.) In practice, large investors with credit teams assign internal ratings to issuers, and thus make decisions based on where an issuer spread compares to its internally rated peers. Rating agency ratings tend to move with a lag versus the “market implied rating,” but that is fine — ratings are not supposed to jump around erratically.

Floating currency sovereigns do not fit into this framework, for the reason of a lack of defaults for financial reasons to build a database. Although Fitch correctly pointed to American political dysfunction, there is no reason to have any confidence that the risk United States has any resemblance to the risks of other issuers with the same rating. Historically, one saw this with the rating of Quebec: bond investors with fiduciary duty needed to develop their own stance on the risk of Quebec bonds around independence referenda.

So, to deal with some of the silliness.

  • No investor of any size is going to care about this downgrade. Anyone with a USD portfolio investment mandate that would preclude them from investing in U.S. Treasuries fixed that mandate a long time ago.
  • Large investors already have views on things like Debt Ceiling risk, and they are not going to change them based on what a couple of analysts at a credit rating agency thinks.
  • Since the large investors do not care, the effect on yields is going to be nil.
  • Small countries like Canada care about their credit rating due to their elites not catching up on this whole “floating currency sovereign” thing, and the reality that most of them issue a small amount of foreign currency debt to finance their foreign exchange reserves. These are not that significant relative to domestic issuance, but the business press (and their readers) lose all sense of scale as soon as amounts are greater than a billion dollars.
  • Europeans love to complain about the U.S. “privilege” of laughing at rating agencies. No, the euro area’s problem is that they threw away their currency sovereignty, so they are stuck dealing with credit agencies.

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(c) Brian Romanchuk 2023

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