Moody's downgrades the U.S. AAA rating, but this time it is very different from 2011

US Credit Rating Faces Downgrade Again, Will the US Treasury Market Experience a 2011-like Uprising?

In 2011, after S&P downgraded the US credit rating, the US stock market faced significant sell-offs, with the S&P 500 index dropping over 7% on that day. The US Treasury also experienced a massive sell-off, pushing the 10-year Treasury yield up by 16 basis points.

However, regarding the market reaction to Moody's downgrade of the US rating, Wall Street veteran Jim Bianco believes that this downgrade may turn out to be a "nothing event," with its actual impact on the market likely to be "negligible."

He argues that after S&P's downgrade in 2011, the market's panic was due to the possibility that US Treasuries might no longer qualify as eligible collateral, forcing many institutions to sell off Treasuries. Bianco stated:

"After 2011, these contracts were rewritten to adjust the requirements for securities to 'government securities,' eliminating specific credit rating qualifications, so rating changes will no longer trigger mandatory actions or sell-offs. Therefore, this will not force anyone to do anything on Monday; nothing has changed."

Why Did 2011 Trigger Market Panic?

Looking back to August 2011, when S&P first downgraded the US from AAA to AA+, the market experienced a moment of panic, especially in the Treasury market, which faced significant sell-offs.

On the day of the downgrade, the 10-year Treasury saw a massive sell-off, with yields rising by 16 basis points, while the 2-year Treasury yield initially rose by 3 basis points.

Regarding the significant sell-off in the Treasury market at that time, Bianco stated on social media that the reason for the "sky falling" was that a large number of derivative contracts, loan agreements, and investment directives prohibited the use of any securities below AAA rating.

"The fear at that time was that US Treasuries might no longer qualify as eligible collateral, which could lead some to violate investment directives or fall into technical default."

In other words, during 2011, many institutions were forced to sell Treasuries, triggering a moment of panic in the Treasury market.

It is worth noting that after an initial surge, the 10-year Treasury yield fell significantly by 56 basis points within a month, dropping from 3% to 2.1%. The 2-year Treasury yield also fell by 9 basis points within a month. Analysts believe there are three main reasons for this:

Although the downgrade was negative for the Treasury market, the demand for safe-haven assets drove investors to buy Treasuries, which is why the 10-year Treasury yield fell significantly in the following month.

At that time, the macroeconomic environment was still facing global economic slowdown and the lingering effects of the European debt crisis, making Treasuries still regarded as the safest liquid asset.

After the downgrade, investors anticipated that the Federal Reserve would further ease policies to offset the impact of the downgrade, leading them to buy bonds, which also lowered Treasury yields

Things are very different now

The issues that arose on the day of the downgrade of U.S. Treasury yields in 2011 no longer exist, because the system has been completely adjusted, and rating changes will no longer trigger mandatory measures or sell-off behaviors.

According to Bianco analysis:

"After 2011, these contracts were rewritten to adjust the requirements for securities to 'government securities,' eliminating specific qualification requirements for credit ratings.

It is precisely because of this change that when Fitch downgraded the U.S. rating to AA+ in August 2023, it had almost no impact on the bond market."

Finally, Bianco stated that technically, Moody's downgrade of the U.S. credit rating did not even change the overall credit rating of the U.S., because the U.S. rating was originally divided into AA+, and is now uniformly rated as AA+.