Ask An Economist

By

Rajdeep Sengupta

Rajdeep Sengupta has been an economist in the Research division of the Federal Reserve Bank of St. Louis since 2006. His main expertise is financial intermediation and corporate finance. Recently, Sengupta also has studied the behavior of subprime mortgages prior to the financial crisis. He is from India and has been in the U.S. since 2001. He is an avid fan of cricket and soccer.

What impact will the downgrade of U.S. debt have on the country's ability to sell debt in the future?

On Aug. 5, Standard & Poor's downgraded the United States' credit rating for the first time in the history of credit ratings. This was a major development because, throughout recorded financial history, U.S. Treasury debt has been considered the safest debt instrument available. The reason for the downgrade was given as "the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate." Taken at face value, this implies increased uncertainty of timely payment of interest and principal on U.S. Treasury obligations.

Typically, the downgrade of sovereign credit ratings is accompanied by a flight of capital away from the country and, in some cases, a sharp depreciation of the sovereign currency. Surprisingly, however, what occurred following the U.S. downgrade was the exact opposite: a sharp decline in both equity and commodity markets and a flight toward U.S. Treasury securities—the subject of the downgrade. Consequently, the yields on the benchmark 10-year Treasury notes fell to their lowest levels since January 2009.

This anomalous behavior can have several explanations. First, despite the downgrade, the financial markets continue to believe in the creditworthiness of the U.S. Treasury. Second, the downgrade occurred during a period of increased uncertainty about the European debt crisis; consequently, U.S. Treasury securities were still a safe haven relative to the sovereign credit risk of other major economies.

Third, immediate market reactions to sovereign credit rating downgrades have often been determined by factors other than the downgrade; following the S&P downgrade of Russia's foreign-currency sovereign credit ratings in December 2008, equity markets in Moscow actually posted gains, buoyed by soaring commodity prices.

In the future, the borrowing costs of the U.S. will almost certainly depend on its ability to resolve some of its long-term fiscal challenges. If uncertainty over U.S. debt repayment continues, global investors will seek a safer alternative to U.S. Treasuries—an alternative that has yet to emerge.

ABOUT THE AUTHOR
Rajdeep Sengupta 
Commenting Policy: We encourage comments and discussions on our posts, even those that disagree with conclusions, if they are done in a respectful and courteous manner. All comments posted to our blog go through a moderator, so they won't appear immediately after being submitted. We reserve the right to remove or not publish inappropriate comments. This includes, but is not limited to, comments that are:
  • Vulgar, obscene, profane or otherwise disrespectful or discourteous
  • For commercial use, including spam
  • Threatening, harassing or constituting personal attacks
  • Violating copyright or otherwise infringing on third-party rights
  • Off-topic or significantly political
The St. Louis Fed will only respond to comments if we are clarifying a point. Comments are limited to 1,500 characters, so please edit your thinking before posting. While you will retain all of your ownership rights in any comment you submit, posting comments means you grant the St. Louis Fed the royalty-free right, in perpetuity, to use, reproduce, distribute, alter and/or display them, and the St. Louis Fed will be free to use any ideas, concepts, artwork, inventions, developments, suggestions or techniques embodied in your comments for any purpose whatsoever, with or without attribution, and without compensation to you. You will also waive all moral rights you may have in any comment you submit.
comments powered by Disqus

The St. Louis Fed uses Disqus software for the comment functionality on this blog. You can read the Disqus privacy policy. Disqus uses cookies and third party cookies. To learn more about these cookies and how to disable them, please see this article.