Moody’s U.S. rating outlook revision is not a game changer.
As a cherry on top of the cake, on Friday, Moody’s changed the outlook on the long-term rating of the United States from stable to negative. Moody's is the only rating agency leaving the country with Aaa, while S&P and Fitch have already downgraded it to AA+. The news didn't generate market volatility because investors had enough time to consider what a downgrade might mean for their portfolios this summer when Fitch downgraded the country to AA+ in August, making the U.S. a split-rated AA+ country. We have discovered that it doesn't matter if the country is rated AAA or AA+. Regardless of the rating, financial contracts refer to “AAA or debt backed by the U.S. Government”; hence, a downgrade wouldn’t provoke a forced unwind of repurchase agreements, loans, and derivatives.
Counterintuitively, a third and last downgrade to AA+ might provoke a rally in U.S. Treasuries. Indeed, if the United States is rated AA+, companies operating in the U.S. will need to be respectively re-rated. How can companies such as Microsoft and Johnson and Johnson have a better rating than U.S. Treasuries? Would these companies be more likely to repay their debt in a credit event than the U.S. Treasury?
Changes in corporate ratings might provoke volatility in credit markets, favoring U.S. Treasuries in the near term.
A bond barbell: a balanced strategy as the macroeconomic backdrop remains uncertain.
The yield curve will continue to steepen. The bear-steepening of the yield curve will likely continue until the year's end as the economy remains buoyant and the Federal Reserve stays on hold. A switch to a bull-steepen is likely next year as the U.S. Economy decelerates markedly and inflation expectations continue to drop.
Within this environment, a bond barbell strategy involving the front part of the yield curve up to 3-year and the ten-year tenor might prove advantageous. In the front part of the yield curve, it is almost impossible to lose money. Two-year U.S. Treasury pays 5% in yield, and this position will be in red only if yields rise by 200 basis points or more. Ten-year US Treasuries also offer an attractive risk-reward rating. Considering a one-year holding period, 10-year notes will provide a total return of -2.25% if yields rise by 100bps, but they will pay +12% if yields drop by 100bps, protecting in case of a recession or a credit tail event.
We remain defensive regarding duration and continue to dislike the ultra-long part of the yield curve. Another test will come next week when the Treasury sells 20-year notes.