Financial markets showed a nervy reaction to the decision by Fitch to strip the US of the top AAA rating on Tuesday

The White House, the US Treasury, as well as many independent and market commentators shrugged off Fitch’s decision to downgrade the US to AA. It was said to be a strange decision by some commentators as there’s been no negative catalyst for such a change recently. At the same time, others argue that it was not a shock because Fitch had moved the US onto negative watch back in May.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy saw a number of reasons to think it is a bigger deal. First up, there is simply the positioning of the markets right now, which seem to have been in an almost exuberantly risk-on mood. Back in 2011, when S&P took away the US’s AAA rating, it sparked a significant fall in risk assets and we fear that the same is possible this time given the exuberance of market positioning. Of course, this means that there is a bigger threat to riskier assets such as stocks and corporate credit than safe assets like treasuries.

For in terms of this ‘safety’ aspect, there is the issue that those investors that can only buy AAA assets for certain portfolios may have to shed treasuries now that two of the three major agencies have the US at AA and not AAA. Admittedly,  this alone could prompt a flood of treasury sales, but there are other question marks about the liquidity of the treasury market that could undermine this safety premium. There have been a number of liquidity problems in recent years, some of which have prompted the Securities and Exchange Commission (SEC) to push for greater central clearing of treasuries.

As usual investors, such as hedge funds, have pushed back against this arguing that it will lift costs that will be passed on to clients. But the fact that the SEC looks almost certain to push ahead with this just shows that it is concerned with the amount of leverage in treasury trading and particularly concerned what might happen if one or more funds get into difficulty.

Even if we argue that the treasury market will still be the magnet for safety flows, and undisturbed by Fitch’s downgrade, there is still the issue of why the downgrade occurred. US debt dynamics are poor, as pointed out by Fitch, partly because fiscal policy has been far too easy in the post-pandemic period, particularly under former president Trump, and certainly not improved upon by current president Biden. This fiscal largesse has seemingly contributed to the rise in inflation and the difficulty of eliminating it because households have been too flush with post-pandemic government handouts.

Hence, even if you argue that debt trends in the US are not worrisome, there is still the issue that fiscal policy is too easy for the purposes of reducing inflation and that just adds to pressure for higher treasury yields. The crisis in the governance of fiscal matters, through the continual debt-ceiling jousting between the White House and Congress, is another concern raised by Fitch.

“In some senses, it seems almost unbelievable that the US can get away with this sort of fractured policymaking and still retain not just relatively low yields but also a relatively strong dollar. Talk of de-dollarisation is rife and, while evidence of this falls a long way short of the vast rhetoric that this subject generates, we do think there is some validity in the view that the US will not be able to enjoy such an “exorbitant privilege” forever. Just whether the end is nigh is hard to say; we suspect it is not, but it is getting closer”, said Mr. Steve Barrow.

But in spite of this last conclusion, Mr. Steve Barrow does not think that the treasury market is about to implode because of the downgrade or any other reason. However, he does see a material risk that the downgrade chips away a bit more at some of the bullishness that has lifted riskier assets this year and hence we’d be cautious that another 2011-style reversal, which will likely prove temporary, is just around the corner.