On Friday, after the market closed, ratings agency Standard & Poor's announced that it had downgraded its long-term sovereign credit rating on the US from AAA to AA+, and maintained a negative outlook.
We believe that this should be seen more as a reaction to the brinkmanship displayed by the politicians in the negotiations over the US debt ceiling - and the risk that this behaviour will be repeated in future - than a reduction in the ability of the US administration to meet its debt obligations. For the moment, the US is still AAA rated by the two other main ratings agencies, Moody's and Fitch.
Our view at Barings has long been that the US credit rating was unsustainable. S&P has had the US sovereign rating on a negative outlook for some time now, and this latest development is unlikely to come as a surprise to other market participants.
In the short term, the Federal Reserve has already confirmed that it will continue to accept Treasuries as collateral, and that financial institutions will suffer no capital penalty for holding US government debt. However, it remains to be seen whether other central banks and regulators will follow suit.
Meanwhile, S&P has already warned that a downgrade to the US sovereign rating would likely trigger a downgrade of Fannie Mae and Freddie Mac, which have their debt guaranteed by the US government. A change in the rating for these government sponsored enterprises could have a knock-on effect on collateral requirements, prompting the sale of short-term paper from these enterprises in favour of Treasury Bills or Bonds.
In the medium to longer term, the response of foreign public-sector money to the loss of the US AAA rating is probably the most crucial unknown factor for financial markets and the path of the global economy. The extent to which foreign central banks and sovereign wealth funds buy US Treasuries to benefit from the security of a US Government promise is unknown. The alternative explanation - that they purchase them to recycle current account surpluses back into their principal client as a form of vendor finance and exchange-rate targeting - appears persuasive to us.
Where we can, we are already generally underweight US Treasuries across fixed income portfolios at Barings. The Treasury market is biased towards the third of our scenarios ("Confluence of shocks" - a global slowdown), having given up most of the inflation risk premium they had discounted. However, the uncertainty associated with the future path of inflation means that this scenario is not fully discounted. With policy still broadly accommodative globally and the amount of noise in various output time series, a rise in bond yields remains a material risk to markets.
If our understanding is correct, however, there should be no earth-shattering market impact from S&P's decision to downgrade the US rating.
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