Paul Brodsky & Lee Quaintance run QB Partners, a private macro-oriented investment fund based in New York.
Takeaway: We believe the downgrade of US Treasury obligations is legitimate and, in one very relevant way, insufficient.
First, the nominal creditworthiness of Treasury obligations is solely a function of controlling the printing press. Congress ultimately retains the legal right to print the nation’s money. It may even decide unilaterally to maintain the US dollar as the nation’s currency or change it. Thus, in light of the prolonged Congressional impasse on raising the debt ceiling, S&P’s downgrade based on Congress’ willingness rather than Treasury’s creditworthiness seems reasonable.
AA+ remains a long way from non investment-grade. US Treasury obligations would become non investment-grade if, for example, Congress were to either maintain the debt ceiling as-is for a long period, which would force Treasury to divert available revenues away from other government services towards principal and interest payments, or if Congress were to completely abandon the US dollar as the nation’s currency, which would force outright default of Treasury obligations.
US Treasury obligations are denominated in US dollars. The current US monetary base, (M0 or currency in circulation plus dollar-denominated bank reserves held at the Fed), is only about 19% of Treasury obligations. So, there is currently insufficient money to repay Treasury debt. Thus, a divided Congress or government may theoretically block further money creation, which would either increase pressure on Treasury to divert available funds towards meeting principal and interest obligations or eventually lead to outright default. We believe S&P’s downgrade is legitimate in light of growing public sentiment, reflected increasingly in the House, not to raise the debt ceiling.
Second, we believe the downgrade is substantially insufficient when viewed in real terms. (Importantly, rating agencies and Treasury are not mandated to address or provide positive real rates or returns.)
The stark difference separating nominal return of principal and interest from the return of inflation-adjusted principal and interest for holders of US Treasury obligations is the critical issue. The necessity to manufacture more money to service and repay existing Treasury debt suggests substantial diminution of the purchasing power of existing US dollars in which Treasury interest and principal have to be repaid. We believe unlevered holders of Treasury obligations are locking-in negatve real interest rates and levered holders of longer duration Treasury obligations are at great risk of capital loss in real terms.
We believe Treasury is already in the process of defaulting in real terms and that such default will be magnified and recognized by more sponsors of Treasury obligations over time.
Non-inflationary solutions to Treasury’s debt and deficit problem, (as well as other public and private sector dollar denominated debtors), are limited to: 1) politically-sponsored austerity (via the the allowance of credit deterioration); 2) a change in tax policy, or; 3) some combination of both. (Base money printing is inflation, per se, and would not reduce debt and deficits, merely lessen the burden of repayment for all current debtors while raising that burden for future revenue producers.)
Although S&P is careful to point out that a downgrade of government obligations does not imply risk among all commerical entities within that domain, we believe this sovereign credit downgrade does imply increasing risk for all US dollar-denominated financial assets. Implicit in S&P’s downgrade is the growing likelihood that the Fed will have to manufacture sufficient base money with which systemic debt can be repaid. (Currently the ratio of dollar-denominated claims to base money is 26:1.)
Thus, the downgrade is effectively a currency downgrade, which seems very reasonable, overdue and, in real terms, insufficient. We would argue that in real terms, US Treasury obligations are non investment-grade. We think Treasury obligations today and always will be money-good, but principal and interest will be repaid with bad money.