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A US Downgrade Won’t Move Interest Rates Because ‘An Elephant Cannot Leave A Pool Without Lowering The Water’
Brad Hintz, a bank analyst at Sanford Bernstein & Co., is almost certain that U.S. Treasuries will get downgraded.
“It is hard to avoid the conclusion that the US Treasury’s rating eventually fall – if not now then sometime in the future,” he wrote in a note emailed to Business Insider.
“Political deadlock; creative government accounting; optimistic economic projections underlying budget projections; and leaders who appear to have never read Paul Samuelson, Adam Smith or John Maynard Keynes: Combine this with politicians on both sides of the aisle, who appear to relish playing games with the US economy while daring the capital markets to react, and you have a prescription for an eventual downgrade.”
But how would the markets, particularly the Treasury markets, react to a downgrade?
“We believe it’s unlikely that there will be a massive flight from US Treasury securities if the US is downgraded,” wrote Hintz. “The big holders of US debt, i.e., the Chinese, the Russians, the Japanese, the Hong Kong and Singapore Monetary Authorities and the largest developed market central banks have positions that are simply too big to move.”
To better understand this, Hintz offers a fun analogy:
Essentially, these central banks face the classic “elephant in a swimming pool” problem. An elephant cannot leave a swimming pool without lowering the level of the water in the pool. And it cannot enter a pool without raising the level of the water. In the case of the foreign central banks’ currency reserves (the elephant), there are only two bond markets (i.e. swimming pools), i.e., the US dollar market and the Euro denominated bond market, that are large enough to accept the banks’ massive currency holdings. And these central banks cannot move their reserves from investments in Treasury to investments in Bunds without incurring massive trading and transaction costs. This “elephant” is stuck with dollars, and Treasuries remain the safest place to invest dollars – so perhaps marginally less buying by the central banks but only marginally.
Regarding those marginal sellers: “There certainly will be selling, but it will be from 1) smaller investors who have the flexibility to move their portfolios in response to America’s changing credit standing and declining currency and 2) sales relating to portfolio duration restructurings by central banks.”
Again, Hintz does not believe these marginal sellers will have a major impact on rates.
After the last downgrade, rates barely budged. In fact they went lower. Stocks plunged, but they came back.
“The post downgrade adjustment period will be challenging for fixed income and equity investors, but the populace won’t have to hoard canned goods and bottled water,” wrote Hintz.