Farewell to risk-free rates as delays hit US credibility

WHETHER or not the deal being worked on intensively in Washington over the past few hours avoids a US downgrade, there is one matter on which all observers agree: the whole debt wrangling saga has dealt a lasting blow to America’s financial credibility.

Credit ratings agencies might yet be persuaded to hold off on a downgrade if the $3 trillion deficit-cutting deal passes smoothly through the legislative process, but there is no putting the genie back in the bottle.

Washington’s last-ditch squabbling and grandstanding over the past week has given the lie to one of the building blocks of the world’s debt markets: that US treasuries represent the world’s “risk-free rate”.

This assumption is built into calculations of overall balance sheet strength (notably, the current Basel II rules), portfolio allocation and asset-backed securities like mortgages.

So any ratings downgrade or re-pricing of US debt will have unknown knock-on effects, particularly because in such scenarios the market’s normal reaction is to flee into “safe havens”, that is, assets like US treasuries…

“OK – We can’t call it the risk free rate any more,” says Newedge’s Bill Blain. “Doesn’t exist. Forget traditional Markowitz asset-allocation portfolio-theory.”

Of course, there is one thing that will keep many investors in treasuries: there is simply nowhere else to go.