On Friday, the credit agency Moody’s downgraded the US rating by one notch to Aa1 (equivalent to AA+).
By now, you’ve probably read tens of opinion pieces arguing this is the beginning of the end, and that there will be dire consequences for the US Treasury market.
Yet, a cool-headed analysis of the situation argues that not much will change for US Treasuries at the time being.
US Treasuries are the most widely used form of collateral in the world due to their high rating, liquidity, deep repo market and solid democratic foundations/rule of law.
Does the downgrade from AAA to AA+ affect that?
The table below shows the Basel risk weights for government bonds under the Standardised Approach: these apply to regulated banks that engage in purchases of Treasuries.
Commercial banks are huge buyers of Treasuries: they use them as regulatory liquid assets (HQLA), as collateral and also sometimes as an asset to hedge interest rate risk on their liabilities.
The Basel regulatory framework introduced 10 years ago has 0% capital requirements for government bonds rated between AAA and AA- for its standardized approach: the downgrade to AA+ wouldn’t make any difference.
Most banks actually choose an internal-rating-based (IRB) approach based on internal models and in that case most jurisdictions apply an exception for any investment-grade rated domestic government bond which automatically assigns them a 0% risk weight.
Bottom line: for banks this downgrade makes no difference at all in the short-run as Treasuries will preserve their risk-weight and their crucial role underlying global repo markets.
Yet, Moody’s is right on one thing: persistent primary deficits (3%+/year and growing) do require a different approach to bond markets than we had during the 2012-2019 period.
By constantly creating money for the private sector at a sustained pace, 3%+ primary deficits contribute to stickier inflation which forces investors to require a higher term premium compensation to own US Treasuries.
The main question remains: will bond markets keep giving a free pass to back-to-back 7%+ deficits in the US?
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