The Recent US Debt Downgrade: One Advisor's Approach to Addressing His Clients

Subject: S&P Downgrades US Debt from AAA to AA+

Dear _______,

After giving the Treasury advance notice around 1:30 yesterday, S&P officially downgraded US debt from AAA to AA+ at 8:00PM (Eastern) last night. S&P said the downgrade “reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.” It also blamed the weakened “effectiveness, stability, and predictability” of U.S. policy making and political institutions at a time when challenges are mounting.

There is much news surrounding the methodology, the timing, the validity, and even the audacity of the move by S&P, but it is official. There’s no undoing it now and it will have impact on stocks, bonds, our economy and the global economy. Just how much remains to be seen because the threat of downgrade has been known and considered by investors and policymakers for weeks. Here’s what we know in a macro sense:

  • European Nations Rally to Voice Backing for US. French, British and Russian officials expressed confidence in the US. Russia said it won’t review its US investment policy.

  • As stocks sank this week at the fastest rates since 2008, investors put their money in US Treasuries at the same rate – despite the continuing threat of downgrade by S&P. Ten-year Treasury yields fell to as low as 2.33% in New York yesterday, the least since October.

  • Asian nations are likely to retain their US Treasury and European governments expressed confidence in the world’s largest economy. China, Japan and Southeast Asian countries are lured to Treasuries as a result of efforts to stem gains in their currencies against the dollar, which impair their export competitiveness. Asia accounts for about half of foreign-owned US debt,

  • Fed says bank capital won’t be affected by downgrade. Banks, which hold Treasuries as a form of capital, won’t need to build larger cushions to protect against possible losses from soured loans, a group of banking regulators, including the Fed and the Federal Deposit Insurance Corp., said in a statement in Washington. “For risk-based capital purposes, the risk weights for Treasury securities and other securities issued or guaranteed by the US government, government agencies and government-sponsored enterprises will not change,” says the Fed.

  • The Fed also said that S&P’s decision will have no implications on its ability to influence interest rates through open-market operations. The Fed in June completed a $600 billion Treasury bond-purchase program aimed at bolstering the economy.

  • Fed Chairman Ben S. Bernanke said last month that the central bank could buy more Treasury securities if the economy appeared in danger of stalling.

  • However, if the Fed does decide to implement a QE3, experts claim that it could send Treasury prices into a tailspin because of the increased potential for inflation. They have been saying this since 2008, and eventually they may be right. Bernanke has said he will do all he can to prevent recession and or deflation.

What does it mean for us, our portfolios, and our plans?

Before the downgrade and even in the face of potential downgrade Treasuries acted like they always do; as a safe haven for uncertain investors, both at home and abroad. Based on the comments above from countries who hold major portions of US debt, there is little reason to think they will change their behavior after the downgrade. Some like Russia, China, and UK said as much. Still, because the US has never been downgraded, there is no way to know for sure. Our investment models are built on studies of vast amounts of historical data regarding how Treasuries perform relative to equities and particularly their effectiveness in hedging stock market risk.

A downgrade in Treasuries may or may not change the behavior of the Treasury market and only time will tell. Dave Loeper, founder of Wealthcare and his team have been studying the possibility of a downgrade and will closely monitor the behavior of 7-10 year Treasuries in a post-downgrade world to determine whether they can remain as the foundation of our risk hedge strategy.

In the unlikely event that Treasuries prove unsuitable for our portfolios, Dave Loeper says that “the next best thing is currently being researched. Currently, there is nothing to replace [Treasuries] that wouldn't dramatically increase portfolio uncertainty. There may one day be some global common currency and debt and perhaps that might show evidence of behavior similar to Treasuries. But it doesn't exist yet.” We will keep you informed of these developments.

More to your specific concerns, market volatility is expected to be high in the coming days. We will stress test your plans frequently as conditions warrant. Should it become necessary to make changes to your plan, we will contact you with new advice to maintain confidence in reaching your important goals. Our advice should be comfortable and acceptable to you as we have already carefully considered remedies unique to you and ordered according to your priorities during our previous planning sessions.

We are with you through these challenging times. By planning, you have practiced proactivity, rather than reactivity. Now is not the time for panic, but for prayer, calm, and honest communication.

Sincerely,

Sam Bass

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