America's Sovereign Debt Credit Rating and Interest Rate Imponderables

Thursday, Aug 4, 2011

I'm frequently asked what is going to happen when the U.S. Treasury's AAA credit rating is downgraded.

First, consider this news article: Moody’s Affirms U.S. Rating, Warns of Downgrade.

Here are my predictions, in a nutshell:

We can expect continued credit market volatility. The recent debt limit increase did nothing to correct the basic problem. The U. S. government spends more than it takes in, so its residual payments are growing, inexorably. As this insanity continues, at some point U.S. Treasury paper will lose its AAA luster. that will initiate a very ugly chain of events that will play out something like this:

  1. One of the major credit rating agencies will drop the credit rating, most likely to the AA+ level.
  2. All of the other rating agencies will immediately follow suit.
  3. Subsequent Treasury auctions may fail, or more likely rates will have to jump by 100 basis points (1%), or more.
  4. This higher rate will ripple through the global credit market.
  5. As the cost of borrowing money goes up, several things happen:

The next phase is difficult to predict, but there are several possible outcomes:

There could be more failed public debt auctions, followed by further credit rating cuts. If that happens, the interest rates will rise repeatedly, as the cleansing of the debt market continues: "Lather, rinse, repeat." In the long run, all of the bad debt will be driven out of the system, but it will be a slow, agonizing process. Government meddling will only prolong the agony. Meanwhile, precious metals prices will rise. If there are repeated ratings cuts of U.S. Treasury paper, then I would not be surprised to see $90 per ounce silver and $1,950 per ounce gold.

Credit spreads will eventually adjust, as the yield curve stabilizes. But in the short term, some of the currency carry traders will suffer huge losses. (Since they depend on stable Forex rates, and stable interest rates.) Presently, the U.S. Dollar is drifting downward (at 73.955, the last time I checked the USDI), but it will likely plummet when there is a credit downgrade. You can also expect to hear about huge derivatives losses, and here we're talking about trillion dollar losses.

There will also be lots of hedge funds going under. As I explained in SurvivalBlog back in 2007, hedge funds make their money by "borrowing short and lending long." That works magnificently in a stable credit market, and investors make piles of money. But when interest rates spike, hedge funds often suffer huge losses. Mark my words: The big hedge fund collapses will be preceded by announcements of redemption suspensions. Beware.

What about the Euro? The EU nations are having some big problems of their own, and they may come to a head at the same time that the U.S. Dollar goes through its crisis. I have a friend who is a well-placed private capital manager. I respect his opinion. He recently sent me this thumbnail assessment of the Euro and the Dollar:

"I suspect that over the next few years the Euro will come apart - not tomorrow. It will take time. Italy is also a basket case and with the third largest sovereign debt market in the world, [so] it's difficult for "Europe" to save.

Apart from financial market weakness the economies will roll on with Greece becoming inexpensive to visit again and German export growth will slow as the Deutschemark becomes incredibly strong.

In the US, I just don't see how the government can stop spending money. While everyone talks about wanting less government, everyone has a mother, father, aunt, uncle, etc who benefits from Medicare and Social Security. Those two items and unemployment account for roughly two-thirds of all government expenditures. They can't balance a budget without tackling those three items. Yet everyone wants them and I will bet politicians who take those programs apart will get fired by the voters. (i.e., not get re-elected.)

So, I suspect the greatest threat to personal wealth is inflation as deficits and quantitative easing continues.

What's the alternative? The Fed will ensure that short term rates will stay low for a while especially with the nervousness about the Euro people will look to the dollar. Again, over a decade or so the US dollar will gradually no longer become the world's reserve currency as countries look to alternatives. Recently the Middle East and China agreed a major oil deal which was not priced in US dollars. The Chinese Yuan would be a good medium term bet. Everyone knows the last year has seen more than the official inflation. Inflation will continue if not accelerate so keep that in mind when thinking through what to do."

The long term outcomes from what I've outlined are all ugly. If the U.S. somehow manages to re-inflate and bail out some sectors, then we may see a few years of illusory "recovery". But at some point a big bust is inevitable. We could then see a devastating credit and currency collapse. That would result in a global depression that might last for several decades. Stock up and prepare to hunker down. If you don't already have country cousins that you can rely on, then it is high time to establish your own retreat.


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