Following Friday’s downgrade by Standard & Poor’s to AA+ from AAA, you might be inclined to think U.S. Treasury bonds are destined for the trash heap.
Especially since the agency is keeping America on negative watch and threatened another possible downgrade in two years.
But let’s get real.
The downgrade shouldn’t have come as a surprise. After all, S&P has been warning about it since April.
And while I’ll concede it’s not a positive development, I assure you it doesn’t undermine the safety of U.S. Treasuries.
No Fire Sale Coming
A sovereign debt downgrade might equal disaster for almost any other country, prompting investors to sell their government bonds en masse.
But the United States is the exception.
Why? Because foreign buyers simply don’t have any “alternatives to the Treasury market in terms of depth and liquidity,” as Vassili Serebriakov, Currency Strategist at Wells Fargo says.
Case in point: The United States has just more than $14 trillion in bonds outstanding. Meanwhile, the next biggest issuers of AAA-debt have less than $2 trillion.
So foreign buyers looking to park literally hundreds of billions of dollars in relatively safe, liquid assets have no other choice. It’s U.S. Treasuries or nothing else. Period.
Such unparalleled liquidity and consistent demand ultimately translates into significant downside protection. Even more so, when you consider that foreign investors really can’t afford to sell their U.S. Treasury holdings. Not unless they want to sabotage their country’s own economic prosperity.
Until Death Do Us Part
It’s important to understand that a sudden sell off in Treasuries would spark a collapse in the value of the U.S. dollar. And that’s the last thing foreign investors want, particularly those in Asia.
They rely on “weaker” currencies in relation to the U.S. dollar to boost demand for their exports.
In other words, a dramatically weaker U.S. dollar would put a dent in economic growth for these countries in short order.
So instead of rushing for the exits, foreign investors are all but guaranteed to hang tight to their U.S. Treasuries… let their export-driven economies keep chugging along… and hope that the United States eventually gets around to fixing its problems.
Don’t just take my word for it, either.
Foreigners Still Believe in the “Full Faith”
The latest comments coming from foreign investors reveal their commitment to stay the course:
- Government officials in Japan said their faith in United States remains strong. The country owns the second-largest amount of U.S. government debt.
- The world’s third-largest foreign holder of U.S. debt, the United Kingdom insists the dollar remains “the key international currency,” according to U.K. Business Secretary, Vince Cable.
- Russia, one of the 10-largest holders of U.S. government debt, said the rating downgrade “can be ignored.”
- And following an emergency meeting, South Korea affirmed its confidence in U.S. Treasuries.
Here’s another key point to understand: Foreign investors hold about $4.5 trillion worth of Treasuries, or about 30% of outstanding U.S. government debt.
The remaining 70% is held by domestic investors. And they’re not about to suddenly hit the sell button, either.
All Good on the Home Front, Too
How can I be so sure? Simple. The largest domestic holders of U.S. Treasuries are the Federal Reserve (thanks to quantitative easing programs) and the Social Security Trust Fund.
Combined, they’re holding $4.3 trillion worth of Treasuries, or roughly the same amount as foreign investors. And even the village idiot understands that these two entities aren’t about to liquidate their holdings
The other major domestic investors in U.S. Treasuries are insurance companies, banks and mutual funds. And the downgrade didn’t trigger any regulatory requirements for them to hit the sell button. So we can expect them to hold tight, too.
The Market Always Knows Best
If you’re still not convinced the debt downgrade changes nothing, consider the latest trading activity in U.S. Treasuries.
In the last month, yields on 10-year Treasuries have fallen by almost 1%.
Remember, bond yields and prices have an inverse relationship. So the drop in yields means that investors have been net buyers, not sellers.
Heck, in the first trading day after the debt downgrade, Treasuries are still rallying. And that wouldn’t be happening if Treasuries were suddenly less safe.
Bottom line: The debt downgrade amounts to nothing more than a stern warning to Washington to get its financial house in order. Let’s hope they listen to the wake up call. In the meantime, U.S. government debt remains a safe investment.
Ahead of the tape,