The sovereign credit rating of the U.S. will be cut as “fiscal theater” plays out in the world’s biggest economy, according to Pacific Investment Management Co., which runs the world’s largest bond fund.
“The U.S. will get downgraded, it’s a question of when,” Scott Mather, Pimco’s head of global portfolio management, said today in Wellington. “It depends on what the end of the year looks like, but it could be fairly soon after that.”
The Congressional Budget Office has warned the U.S. economy will fall into recession if $600 billion of government spending cuts and tax increases take place at the start of 2013. Financial markets are complacent about whether the White House and Congress will reach agreement on deferring the so-called fiscal drag on the economy until later next year, Mather said.
In a “base case” of President Barack Obama being re-elected and Congress becoming more Republican, there is a high likelihood an agreement “doesn’t happen in a nice way, and we have disruption in the marketplace,” he said.
Policy makers probably will agree on cutbacks that would lower economic growth by about 1.5 percentage points next year, Mather said. They may roil markets by discussing scenarios that would lead to a 4.5 percentage-point fiscal drag, he said.
Bill Gross, manager of Pimco’s $278 billion Total Return Fund, this month said that the U.S. will no longer be the first destination of global capital in search of safe returns unless fiscal spending and debt growth slows, saying the nation “frequently pleasures itself with budgetary crystal meth.” He reduced his holdings of Treasuries for a third consecutive month to the lowest level since last October.
S&P last week cut Spain’s debt rating to BBB-, the lowest investment grade, and placed it on negative outlook.
“Almost all sovereigns with poor debt dynamics are going to get downgraded, we’re just talking about the pace,” Mather said. Credit rating companies “have been slow in downgrading some sovereigns, but we think the pace probably picks up in the year ahead.”
Bond investors needn’t worry that a rating cut will hurt returns. About half the time, government bond yields move in the opposite direction suggested by new ratings, according to data compiled by Bloomberg on 314 upgrades, downgrades and outlook changes going back to 1974.
Spain’s bonds have rallied over the past week, pushing the yield on 10-year notes down by 16 basis points to 5.47 percent yesterday, the lowest closing level since April.
Benchmark U.S. Treasury yields have dropped to records since Standard & Poor’s cut the nation’s credit rating to AA+ from AAA on Aug. 5, 2011.
The 10-year rate was at 1.81 percent as of 11:04 a.m. in Tokyo, down 59 basis points since the day before the ratings reduction, after reaching a record-low 1.39 percent on July 24 of this year.
Credit-default swaps tied to U.S. debt, which typically fall as investors’ perceptions of creditworthiness rise and increase as they deteriorate, have dropped to 31.4 basis points from 55.4 basis points on the day of S&P’s downgrade and a record 100 in February 2009, according to data provider CMA. The firm is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market.
Credit rating firms may also be discounting an improvement in U.S. debt levels, which have shrunk to a six-year low. Total indebtedness including that of federal and state governments and consumers has fallen to 3.29 times gross domestic product, the least since 2006, from a peak of 3.59 four years ago, according to data compiled by Bloomberg.
French debt maturing in a year or more rallied 7.8 percent since before S&P cut the sovereign rating to AA+ on Jan. 13, more than double the gains for the global government bond market, according to Bank of America Merrill Lynch indexes.
Pimco forecasts global growth of 1.75 percent in the year through September 2013, weighed down by a euro-zone recession and a slowing pace of expansion in China.
“It’s a pretty dismal world growth outlook,” Mather said, adding that it will be difficult to return to former levels of growth in many of the world’s biggest economies because of the levels of debt, structural changes in the labor market and slower growth in the working-age population.
Those changes mean that a 2 percent expansion in the U.S. may in the future be seen as good growth, not the 3 percent that investors have been used to, he said.
It is difficult to see China’s growth continuing at a 7 percent pace, considering demographic changes and the challenge of maintaining expansion as the economy moves to a domestic consumption model from one based on exports, he said.
China’s economy expanded 7.4 percent in the three months ended Sept. 30 from a year earlier, slowing for a seventh quarter, the National Bureau of Statistics said today.