Standard & Poor’s downgraded the credit rating oflong-term U.S. sovereign debt from a stellar AAA toAA+ based on “political risks and rising debt burden” with a negative outlook as of Friday, August 5.1Thisrepresents the first time that one of the three majorcredit rating agencies has downgraded U.S.sovereign debt since such ratings were initiated.

This action ostensibly has the potential to detractfrom the marketability of, and increase the costsassociated with, U.S. sovereign debt in the future.In particular, we must be sensitive regarding theperceptions of overseas investors to thisannouncement, noting that foreign investors nowhold approximately 50% of U.S. sovereignmarketable debt.

Finally, we believe that this action underscores theutility of CME Group Treasury futures and options onfutures products as risk-management tools in anuncertain economic environment.

S&P Announcement

On August 5, S&Pannounced that it had “lowered … [its] … long-termsovereign credit rating on the United States ofAmerica to ‘AA+’ from ‘AAA’ and affirmed the ‘A-1+’short-term rating … [t]he downgrade reflects … [its]… opinion that the fiscal consolidation plan thatCongress and the Administration recently agreed tofalls short of what, in our view, would be necessaryto stabilize the government’s medium-term debtdynamics.”2

This action is taken as a reaction to the recentacrimonious partisan debate over the increase in theU.S. debt ceiling. This issue resulted in what hasbeen described by many analysts as a game ofpolitical brinksmanship featuring Republicans andDemocrats forwarding their own spending andtaxation agendas.

The political debate was, at least temporarily,resolved on Tuesday, August 2, when PresidentBarack Obama signed legislation that called for a$2.4 trillion increase in the U.S. statutory debtceiling, in two stages, from the previous level of$14.3 trillion. This legislation further called for some$2.2 trillion in spending cuts over the next 10 years.

While the legislation averted the immediate prospectof a default of the Federal government with respectto its marketable debt or account debts, it failed to resolve the growing fiscal crisis. Further, it did notresolve the fundamental debate over the size andscope of government between Democrats andRepublicans. The Democrats called for revenueraising measures while the Republicans, emboldenedby the growing popularity of the Tea Partymovement, held firm that tax increases were not tobe part of the compromise measure.

As a result, S&P has adopted the “view that theeffectiveness, stability and predictability of Americanpolicymaking and political institutions haveweakened at a time of ongoing fiscal and economicchallenges to a degree more than we envisionedwhen we assigned a negative outlook to the ratingon April 18, 2011. Since then, we have changed ourview of the difficulties in bridging the gulf betweenthe political parties over fiscal policy, which makesus pessimistic about the capacity of Congress andthe Administration to be able to leverage theiragreement this week into a broader fiscalconsolidation plan that stabilizes the government’sdebt dynamics any time soon.”3

Looking forward, S&P is discouraged by the fiscalprojections offered by the Congressional BudgetOffice and other analysts. As a result, “[t]heoutlook on the long-term rating is negative. Wecould lower the long-term rating to ‘AA’ within thenext two years if we see that less reduction inspending that agreed to, higher interest rates, ornew fiscal pressures during the period result in ahigher general government debt trajectory than wecurrently assume in our base case.”4

Return to top.

Debt Ceiling

The legislation passed August 2raises the Federal debt ceiling to some $16.7 trillion.But what does this mean and why do we have a debtceiling?

To begin, let’s distinguish between various types ofgovernment indebtedness. “Debt held by the public”is created when the government explicitly sells debt,often in the form of securities. “Debt held bygovernment accounts” represents financialobligations as a result of programs such as SocialSecurity, Medicare, etc. Total or gross public debt isthe aggregation of debt held by the public plus debtheld by public accounts.

The U.S. Congress passed the Second Liberty BondAct in 1917 which mandated use of long-term“Liberty Bonds” to finance defense spending duringWorld War I. Prior to that point, U.S. indebtedness was generally of a short-term nature with theexception of loans authorized to finance specificprojects, e.g., construction of the Panama Canal.The 1917 Act further instituted a limit on totalfederal debt.

U.S. Debt Subject to Statuatory Limit (Billions USD)The general intent was to make Congressresponsible for managing the debt in an effort tokeep interest costs low. Normally when a nation’slegislative body approves spending, the means toraise necessary funds are implied. But the 1917 Actmade the U.S. one of the few nations to enforce adebt limit apart from its appropriations process.Subsequent amendments to the legislation allowedCongress to establish separate limits on differentcategories of debt, e.g., bills, notes, bonds.

In 1939, Congress repealed those separate limits ondifferent debt categories, providing the TreasuryDepartment with far greater flexibility to issue debtinstruments with maturities that offered lower rates.However, the debt limit was maintained at a levelthat was much closer to the total Federal debtlevels. Consider that in 1919, the limit was at $43billion while total federal debt stood at $25.5 billion.By 1938, the limit was pegged at $45 billion andrelatively close to the $40.4 billion in total Federaldebt.

The debt limit has been increased many times in theintervening years. It ballooned to $300 billion by1945 as a result of massive spending during WorldWar II. Between 1997 and 2001, the Federal budget actually ran at a surplus and, as a result, thelimit held at $5.95 trillion for an extended period.

Since then, however, Federal spending has generallyincreased while tax receipts have generally declined.This has resulted in a spate of rancorous debate inCongress over fiscal policy, often tied to the debtceiling as a focal point of the debate. “Close calls”were experienced in most every fiscal yearbeginning in 2002. But the debt ceiling crisisculminating in the August 2 legislation was possiblythe most serious of these episodes as evidenced byS&P’s downgrade.

Return to top.

Federal Receipts & Outlays

Philosophical Clash

The debate over the debtceiling was about far more than the debt limit.Rather, it was symptomatic of a fundamental clashover the future size and role of the federalgovernment. While both Democrats andRepublicans generally endorse the ideal of abalanced budget, Republicans generally favorholding tax rates to current levels while theirDemocratic counterparts generally favor increasingrevenues through taxation.

The debate was, of course, occasioned by the factthat government spending has ballooned while taxreceipts have declined in the wake of the subprimemortgage crisis. Thus, the 2010 deficit is estimatedat 10.6% of GDP. This represents a completereversal of the situation in 2000 when the U.S. wasoperating at a modest surplus of 2.4% of GDP. Ofcourse, the current deficits are not nearly asfrightening as the 21.5% of GDP deficit reached in1945 during World War II.

Composition of Federal Outlays The composition of Federal spending has changeddramatically over the years. Defense spending hadbeen the largest budgetary line item during the postWWII period up until the early 1970s. But defensespending now takes a back seat to payments toindividuals notably including entitlement programssuch as Social Security, Medicare and Medicaid.These obligations continue to grow in magnitude andnow account for over 15% of annual GDP.

Return to top.

Fiscal Scenarios

The long-term implications offailure to address the burgeoning Federal fiscal crisisbear close examination. In particular, recentanalyses offered by the Congressional Budget Office(CBO) warn of impending risks and fiscal crisis.5The 2011 CBO study offers two alternate budgetaryscenarios as follows.

  • Extended-Baseline Scenario – This scenario assumes that the budget situation moving forward adheres closely to current law. Thus, “the expiration of the tax cuts enacted in 2001, the growing reach of the alternative minimum tax, the tax provisions of the recent health care legislation, and the way in which the tax system interacts with economic growth would result in steadily higher revenues.” Revenues are projected at 23% of GDP by 2035.

    On the other hand, “spending on everything other than the major mandatory health care programs, Social Security, and interest on federal debt – activities such as national defense and a wide variety of domestic programs – would decline to the lowest percentage of GDP since before World War II.”

    This scenario has public debt increasing to 75% of GDP by 2020 and 84% of GDP by 2035.

  • U.S. Gross Public DebtAlternative Fiscal Scenario – This “bleaker” outlook “incorporates several changes to current law that are widely expected to occur … most important are the assumptions about revenues that the tax cuts enacted since 2001 and extended most recently in 2010 will be extended: that the reach of the alternative minimum tax will be restrained … and that over the longer run, tax law will evolve further so that revenues remain near their historical average of 18 percent of GDP.”

    On the spending side of the ledger, “this scenario also incorporates assumptions that Medicare’s payment rates for physicians will remain at current levels … and that some policies enacted in the March 2010 health care spending will not continue in effect after 2021 … spending on activities other than the major mandatory health care programs, Social Security, and interest on the debt will not fall quite a low as under the extended-baseline scenario, although it will still fall.”

    Per this more dire of the CBO’s projections, the public debt would reach 97% of GDP by the year 2020 and 187% of GDP by the year 2035.

2009 Public Debt as % of GDPThere are no absolute prescriptions regarding howmuch public debt a nation may, as a practicalmatter, carry. To put these results into perspective,however, consider that the Maastricht Treaty hadprovided guidelines regarding national economicpolicies as a prerequisite for nations joining theEuro-zone and adopting the Euro as its commoncurrency. Amongst other requirements, the Treatycalls for total sovereign debt to be less than 60% ofGDP and the annual government budget deficit to beless than 3% of GDP.

Under either CBO scenario, the U.S. public debt as a% of GDP would exceed the Maastricht prescriptionby a wide margin. Note that the 2010 budget deficitof 10.6% of GDP already exceeds the Maastricht 3%prescription. All of this would place the fiscalsituation in the U.S. on par or worse than theEuropean nations (including Greece, Ireland,Portugal, Spain, and Italy) which are at the center ofthe ongoing European sovereign debt crisis.6

Return to top.

U.S. Fixed Income Issuance

Impact on Markets

This situation has alreadyexerted a toll on the markets, noting the negativereaction of the equity markets on August 8 with theS&P 500 closing at 1,119.46 and volatility asmeasured by the VIX up to 48%. West TexasIntermediate (WTI) crude oil fell to $81.04/barrel onAugust 8. Gold prices, on the other hand, surgedup to $1,720.80/ounce on August 8 as the metal isviewed as a store of monetary value.

Finally, we have witnessed a rally in the price of U.S.Treasuries with 10-year on-the-run yields falling to ayield of 2.32% as of August 8th. Paradoxically,Treasuries continue to be viewed as a safe haven ofsorts. This result may be somewhat counterintuitive to the extent that Treasuries are thesubject of S&P’s downgrade. However, the real riskof default is viewed as insignificant. Further,Treasuries have been issued in large quantities andare exceedingly liquid. Note that annual Treasuryissuance grew to some $2,304 billion in 2010, morethan triple the $752 billion issued in 2007.

Overseas Holdings of U.S. TreasuriesIn the longer-term, however, the Treasury’s capacityto raise funds through debt sales may be, at leastmarginally, impacted. Certainly, investor nationssuch as China are publicly expressing concern,noting that China held some 12.5% of marketableU.S. debt securities as of May 2011 while Chineseequity markets reacted very negatively to thedowngrade in U.S. long-term sovereign debt.

As a result, Chinese authorities issued a stingingcommentary through the Xinhua news agency onSaturday, August 7th, denouncing the U.S. as a“debt addict” and calling for international supervisionof the U.S. dollar. To the extent that Chineseforeign reserves are largely held denominated inU.S. dollars and the Peoples Bank of China (PBC) isthe U.S.’s largest creditor, “China has every rightnow to demand that the United States address itsstructural debt problems and ensure the safety ofChina’s dollar assets.

Return to top.

Major Foreign Holders of Marketable U.S. Debt (May 2011)


The recent debt ceiling crisisculminating in S&P’s downgrade of U.S. sovereign debt highlights the seriousness of the fiscalproblems faced by the U.S. federal government.

Hard choices in terms of revenue raising andcutbacks in spending programs, possibly includingthe heretofore sacrosanct entitlement programs,remain on the board. Failure to address these fiscalconcerns may very well result in further declines inthe U.S. sovereign creditworthiness and some longterm increases in the general cost of funds.

Note that CME Group offers a full suite of Treasurybased derivatives products designed to assistinvestors in managing the volatility associated withTreasury investments. We suggest that theseproducts are currently more relevant than ever forinvestors, both domestic and abroad, in light ofthese ongoing fiscal challenges.

For more information, please contact…

John W. Labuszewski, Managing Director
Research & Product Development

Michael Kamradt, Director
Interest Rate Products

James Boudreault, Director
Research & Product Development

1Standard & Poor’s Global Credit Portal Ratings Direct,“Research Update: United States of America Long-TermRating Lowered to ‘AA+’ On Political Risks and RisingDebt Burden; Outlook Negative” (August 5, 2011).

2 Ibid.

3 Ibid.

4 Ibid.

5 See “CBO’s 2011 Long-Term Budget Outlook,”Congressional Budget Office (June 2011) and “FederalDebt and the Risk of a Fiscal Crisis,” CongressionalBudget Office (July 27, 2010).

6There remains a major distinction between the fiscalsituations in the U.S. and these peripheral Europeancountries. Specifically, The U.S. has not subordinated itspolicies to the European Central Bank (ECB) as haveEuro-zone nations. Thus, the U.S. controls its own fiscaland monetary policies.