So You Don’t Want US Debt. What Are Your Options?

Exactly nobody who cared to weigh in on Wednesday believed Fitch’s decision to pull the trigger on a US debt downgrade was likely to have severe ramifications for markets.

There are no alternatives to US Treasurys. There are other ostensible safe-havens, but not withstanding recent liquidity concerns and putting aside the worst US rates volatility since the financial crisis, the Treasury market remains the deepest and most liquid in the world. That’s one boilerplate talking point that happens to be completely true.

It’s not as if the entire world can just “rotate” into bunds or JGBs or CNY bonds. No other market is capable of absorbing capital flows on the scale of the US Treasury market. It’s logistically impossible. But let’s pretend it isn’t, because if the discussion stops there (where it certainly could), it’s no fun.

So, you don’t want US debt. Would you prefer JGBs? That market barely functions at all, and prices are still administered by the central bank, which owns half the outstanding bonds. What about bunds (with a “u” in there)? Germany is mired in a multi-quarter, stagflationary recession and came very close to a complete industrial meltdown in 2022, when the perils of the country’s energy dependence were laid bare. And besides, Germany isn’t a monetary sovereign. If, God forbid, they were to experience some kind of deep, dark depression due to an expansion of the war or some climate-related disaster, they couldn’t print money to fix it. As for CNY bonds, that’s a joke. Forgive me, but it is. For one thing, there aren’t nearly enough of them to go around, especially not if Beijing wants to ensure an adequate supply of paper for domestic users, but more importantly, nobody who wasn’t compelled by geopolitical necessity would tie up a sizable share of their reserves in the liabilities of a totalitarian dictator.

What about smaller, less influential countries which carry AAA ratings? Well, they may be decent alternatives in some respects, but the idea of replacing your Treasury allocation with a “mix” of debt issued by Canada, Denmark, Switzerland, the Netherlands and Luxembourg seems silly. And don’t tell me about Norway. That debt is effectively guaranteed by the sovereign wealth fund, and guess where that money is invested? (Hint: Overwhelmingly in US assets.)

Additionally (and this runs the risk of coming across as uncouth), pretty much every AAA country (with the exception of maybe Singapore) depends on the US for security. That, to me, is a problem when it comes to classifying “safe” debt. How safe are JGBs really? With the push of a button (and a little luck to account for the high odds of malfunction), Kim Jong-Un could eliminate the obligor. And I can assure you he wouldn’t make JGB holders whole. Russia could likewise eliminate quite a few of Europe’s AAA-rated governments overnight. And as far as anyone knew before Vladimir Putin inadvertently exposed his military as an inept paper tiger, Russia had the wherewithal to overrun and conquer most European countries without resorting to a nuclear exchange. And what is Canada without the US? A big oil field populated by pacifists that’d look pretty enticing to acquisitive countries with the military wherewithal to indulge their worst instincts. The only thing that makes such nightmarish outcomes impossible is the American military deterrent. It’s not entirely inaccurate to suggest the US government is the ultimate guarantor of debt issued by any nation which depends on US security guarantees.

And what about natural disasters? No other AAA-rated nation (besides Canada) has a large enough contiguous landmass. Some of those countries could be wiped off the face of the Earth by Mother Nature in one, angry fell swoop. Even Canada is burning, but at least it couldn’t be submerged overnight by a big wave or an overflowing river. Make no mistake, that matters in the climate apocalypse era. Put as a question: Who pays interest and principal on Aussie bonds if there’s no Australia?

Those are all just thought experiments, meant mostly for (dark) comedic value. The main point as it relates to alleged “alternatives” to US debt following Fitch’s downgrade is that there aren’t any. Again: No market can absorb the capital flows the US Treasury market absorbs. It’s impossible. US bonds, paper and other government obligations are the only viable savings recycling vehicle for the world’s major exporters (the ones allowed to hold them anyway). Relatedly, and just as importantly, those securities are the collateral that makes the world spin.

This whole discussion is asinine. Arguably, the ratings agencies shouldn’t be allowed to downgrade Treasurys, because if they pushed the issue too far (which they wouldn’t), they could in theory create a bizarre situation wherein various ratings-related mandates required some holders of US debt to sell it, effectively forcing those investors to choose between running afoul of their own rules or selling all of their Treasurys. I should note that such an outcome is exceedingly unlikely. Investors took steps after the 2011 downgrade to preempt it. “Investment mandates have long since been adjusted from ‘AAA’ requirements to a version of ‘US Government quality or the equivalent’ in a move that has largely defanged this and any future downgrade,” BMO’s Ian Lyngen and Ben Jeffery remarked. Every major bank said some version of the same thing+ on Wednesday.

With all of those caveats, there was something to say for Fitch’s decision. As discussed at length in “The US Deserves Its Credit Downgrade,” America’s problem isn’t fiscal recklessness, it’s institutional decay. America can’t go broke financially, but it can be bankrupt in social capital terms. And it can succumb to autocracy. Those risks are real, and Fitch was right to highlight them, if only obliquely.