Market Perspective

INVESTMENT MANAGEMENT

July 28, 2011

ING Market Intelligence Series

Debt-Ceiling Debate: Outcomes and Implications for the Fixed Income Markets

Scenario: Debt Ceiling Raised; Credit Downgrade

A limited budget plan is passed, and the debt ceiling is raised. However, the major NRSROs, having lost faith in the U.S. government’s ability to manage the country’s debt in a manner consistent with a AAA rating, downgrade Treasuries to AA. Timing is uncertain, of course, as rating agencies may move to downgrade at different times, resulting in temporary split ratings (AAA/ AA) for a period.

• While uncertainty will create volatility — particularly in the Treasury yield curve as well as in the markets for agency debentures and agency mortgage-backed securities (MBS) — we do not anticipate that the ratings downgrade will have a significant impact on the ability or willingness of major market participants to continue investing in these securities. Even at AA, we believe U.S. Treasuries would still carry enormous creditworthiness in their ability to pay despite the events that brought about the downgrades. Further, there are very few credit-like alternatives available in size relative to the U.S. Treasury, agency and agency MBS markets to warrant a global wholesale shift out of these instruments into meaningful alternatives.

A downgrade scenario, however, would very likely result in increased near-term volatility as investors around the world try to ascertain what a downgrade to U.S. debt implies for their current portfolios and future investment decisions. Treasury yields may rise, and the yield curve could steepen at the long end in the absence of any new significant sources of demand (e.g., QE3, China, etc.). Credit spreads will widen, and high yield bonds will underperform investment grade corporates. The U.S. dollar will sell off, but mostly against “safe” currencies like the Japanese yen and Swiss franc.

Scenario: Debt Ceiling Raised; No Downgrade

A more limited budget plan is passed, and the debt ceiling is raised. However, the major nationally recognized statistical rating organizations (NRSROs) are not convinced that enough has been done to put the country on a fiscal path worthy of AAA ratings over the long term. Although the NRSROs do not act to downgrade Treasury debt at this point, they become the driving force behind the continuation of the fiscal debate and potential for more positive long-term structural solutions.

• The NRSROs — Standard & Poor’s, most prominently — become critical arbiters of the fiscal credentials of the political parties and candidates through the 2012 election cycle.

• The focus on the negative fiscal state of the U.S. will continue; however, with no imminent risk of default, the Treasury market will be dominated by soft economic growth and rising demand for Treasuries from domestic banks seeking to shore up their capital bases. Treasury yields would likely become more range-bound. Volatility will decline, and credit spreads should remain broadly stable. This could be a very good time for carry-oriented credit and currency strategies unless the U.S. economy falters. In this environment, the U.S. dollar trades with a softer tone.

AtlantaFixed Income Team

With less than a week remaining until the August 2 debt-ceiling deadline, Washington remains gridlocked. While we believe a default scenario is a low-probability event, a downgrade of the U.S. debt rating has increased in probability over the past weeks. Below, we outline four potential outcomes to the current crisis, along with some thoughts on the impact each would have on the fixed income markets.

July 28, 2011

Scenario: Debt Ceiling Raised; Ratings Affirmed

A major budget plan is passed, the debt ceiling is raised and the major NRSROs agree that the legislative process has delivered a credible path for the long-term maintenance of AAA ratings.

• Risky assets will enjoy a relief rally as the market’s focus returns to the economy and business cycle developments. Unfortunately, cyclical indicators are not looking that strong at the moment, which is a negative for credit sectors like investment grade corporates or high yield bonds. However, the reduction in volatility from the “end” of the 2011 U.S. fiscal crisis will provide an offset to weaker growth, and spreads should remain stable across the credit curve.

• Perversely, better fiscal news should result in a near-term selloff at the longer end of the Treasury market and perhaps some modest bear-steepening of the Treasury curve as the demand for risky assets picks up and money is allocated out of Treasuries. The U.S. dollar may initially rally, especially if Treasury yields back up a decent amount, but the pro-risk environment will eventually be negative for the dollar as investors seek higher returns elsewhere.

Scenario: Debt Ceiling Not Raised

Budget talks break down, and the debt ceiling is not raised.

• In short, take the downgrade scenario (Scenario #2) and ratchet it up several times — a downgrade is one thing, but a default is something else entirely.

• The doomsday scenario would likely result in financial calamity, with the dollar weakening considerably and all U.S.-based financial assets underperforming.

• This said, this does not immediately necessitate a missed payment on government debt obligations, as the Treasury can still roll existing debt maturities without increasing the overall stock of debt. The Treasury, acting with the Federal Reserve as its banker, will decide which U.S. government checks clear and which do not.¹

Beyond the above scenarios, there is also a reasonable probability that the Fed will intervene if there is any adverse effect on the Treasury market from a downgrade or “temporary default”. In this scenario, the Fed would likely implement QE3, buying Treasuries to keep a lid on bond yields since any significant and lasting rise in yields would be detrimental to the overleveraged U.S. household sector.

The Fed has plenty of incentive and experience in stabilizing markets should unrest occur in the Treasury, agency or MBS markets. In fact, it can utilize the same approach used to stabilize the MBS market in 2008–09 — specifically, buying assets from investors who no longer want them at current prices. The MBS market is about as big as the Treasury market, so it is quite conceivable that the Fed could enact a large-scale Treasury buying program to stabilize the bond market. Since U.S. Treasury debt is dollar-denominated, the Fed can easily ensure that all obligations of the U.S. government are met; having bought over a trillion dollars of mortgages and over half a trillion dollars in Treasuries in the aftermath of the financial crisis, the Fed is clearly not afraid to print money in size where necessary to support markets.

However, while the Fed can have some success in inflating bond prices, it has no influence over credit ratings and, thus, the impact that a downgrade may have on broader markets and the knock-on effect for U.S. consumers and the overall economy.

While the Fed’s potential reaction can’t be fully scripted at this time, we do believe that should the debt ceiling not get raised, the U.S. dollar would likely selloff somewhat significantly. U.S. trade partners — particularly China and Japan — would likely look to intervene in the currency markets in an attempt to mitigate a significant U.S. dollar selloff versus the renminbi and yen. In fact, the recycling of dollars purchased by China and Japan as part of a currency market intervention might be the only new inflows into the Treasury market at that time. As the U.S. does not have any foreign-currency debt to worry about, any decline in the dollar that results from the printing of money to prop up domestic debt markets may be entirely acceptable by Washington (if not welcomed).

We recognize this is a highly fluid situation, and we will provide an updated commentary should developments warrant one. In the meantime, feel free to contact your ING representative if we can be of any service or help answer any questions you may have. n

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