BNY Mellon: The USD and Sovereign Downgrades

January 18, 2019

By Simon Derrick, Chief Currency Strategist, BNY Mellon

By Simon Derrick, Chief Currency Strategist, BNY Mellon

James McCormack, global head of sovereign ratings at Fitch, has said that the agency could cut the US sovereign credit rating later this year if the shutdown causes the government to hit its debt ceiling.

With this in mind, it’s worth revisiting 2011 when S&P downgraded US sovereign debt in the aftermath of protracted discussions about the debt ceiling.

A warning of S&P's concerns came on April 18, 2011 when it issued a “negative” outlook on its US sovereign debt rating due to concerns about the scale of the budget deficit. This was followed on July 14 by the agency placing US sovereign debt on a negative watch.

Although Congress voted to raise the debt ceiling at the start of August, S&P went ahead with a downgrade on August 5, citing concerns about the “effectiveness, stability, and predictability of American policymaking and political institutions” while noting that "the political brinkmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed”.

While plenty of criticism was aimed at S&P in the aftermath of its decision, the key reaction came from China.

Writing in the FT on the morning of the downgrade, Yu Yongding, a former academic member of the PBOC’s monetary policy committee, argued: “If there is any lesson China can draw from the US debt ceiling crisis, it is that it must stop policies that result in further accumulation of foreign exchange reserves”.

This was followed a few days later by some fairly brutal criticism by Xinhua, which called for “international supervision over the issue of USDs” and for the US to “live within its means”.

Although the USD did decline in the aftermath of the initial warning from S&P on April 11, this was part of a broader trend that had begun to emerge in mid-February, as concerns about a potential government shutdown began to emerge.

This was also the point that US Treasury yields peaked out and a six-month old rally in the S&P 500 stalled. Similarly, the move on July 14 had little impact on sentiment.

Even the move on August 5 did little to change sentiment that was already resolutely negative by this point.

The S&P 500 had suffered badly from the start of the month while Treasury yields had fallen sharply following news that the debt ceiling was to be increased until 2013, while spending would be cut by USD 2.4 trn over the next 10 years. Throughout this period the USD remained relatively stable.

So what impact did the move actually have?

While there is little to indicate that S&P’s actions had any material impact on sentiment (indeed, there were flows back into the USD from the end of April onward - see chart below), what is certainly true is that the debate within China over currency, interest rate and capital account liberalization picked up sharply post-downgrade.

This, in turn, is a story that is still playing out.