U.S. Downgrade: The First Wall Street Analyst Reactions
If you’re having a good weekend, you’re a person who doesn’t have any money in the markets. For everyone else, this is a weekend of looking for a smart – and hopefully soothing – map of thoughts on where we are right now, and what this will mean for our economy, our jobs, our banks, our homes, and our peace of mind.
Wall Street analysts and strategists, of course, are not taking the weekend off. Even while some are attending weddings or traveling, they’re making calls and talking to people and making some educated guesses about what happens over the next week and after that. They’re sending out their thoughts from Gmail accounts and offering up cellphone numbers.
Here’s a brief summary of the high points of some of the reports this week from Guy LeBas, fixed income strategist for Janney Montgomery Scott; David Semmens of Standard Chartered; Ajay Rajadhyaksha, the head of U.S. fixed income strategy at Capital of Barclays Capital; and Hilary Kramer, editor of newsletters on Game Changer Stocks and BreakOut Stocks. (If there are more analysts cranking out good thoughts, send their reports to me at hmoore AT marketplace DOT org.)
Does this even matter?
Short answer: psychologically yes. Financially, probably not too much in the short term because Treasury bonds and the US dollar have a lock on the world markets. Over time, however, expect investors to start moving away from Treasuries and the dollar to diversify their investments.
Reason: This probably won’t completely destabilize the world markets because everyone guessed this was coming. The U.S. has been on negative outlook from Moody’s and S&P for months, and S&P said it was becoming more concerned in recent months.
Glossary: The US dollar is called the world’s “reserve currency” because it is considered so safe that other countries stockpile dollars in case their own currencies drop in value. The fact that the US dollar is the reserve currency is what made us feel invincible – a sense that was wrong and misplaced, as it turns out.
When Semmens talks about “mandates,” he means the rules that many professional investors have to follow. Every investor has a different mandate, but many of the biggest ones are required to put their money into AAA securities for safety.
The loss of the US’ AAA credit rating is a serious psychological event. It is also, however, something which the markets have started coming to terms with in the last two weeks. In the scheme of things, S&P’s action offers little we don’t already know. The markets are aware of deteriorating US credit quality, and have been attentive to the potential for a downgrade. Ultimately, after a period of likely extreme volatility (20bps intraday trading ranges on 10s), economic fundamentals will prove more important than the difference between AAA and AA+.
While this is a significant announcement for political and historic reasons, the actual impact of a rating change on the US Treasury market should not be significant. Once the deficit reduction plan passed earlier this week was considerably less than $4tn, a downgrade seemed only a matter of time. Perhaps the only element of surprise was whether the rating agency would back up its words with the actual action – and it turns out they did. …We made the case two years ago that based on fiscal metrics alone, the US was no longer a AAA-rated sovereign. But – and this is an extremely important ‘but’ – the credit of a country is not simply a function of fiscal metrics. Two other important variables are political will and the reserve currency. While the political system in recent months has appeared dysfunctional, the reserve currency status provides the US with a big advantage – our funding costs are not simply a reflection of our balance sheet.
What is incredibly important is that we do not believe that will significantly alter the attitude of the world to Treasuries despite the potential for extreme volatility when markets open across the world on Monday. There simply is no alternative debt market that is as deep, particularly with Europe having its own debt issues. Both Moody’s and Fitch have the US rated as AAA, although Moody’s has the US on negative watch. Most mandates would appear to refer to US securities rather than the specific rating itself and even if they require a credit grade they use two out of the three rating agency’s assessment as a guide. This will however hasten the shift away from the USD and USTs at the margins going forward.
Yes, even with the other two agencies staying with AAA, there are some funds globally that might diversify away from our debt and the cost of funding could conceivably rise. The biggest hit will be to the housing market that’s on life-support.
What will this week look like for financial institutions all over the world?
We’ll throw this one to Seth Martin, with translations after each of his points so regular people can understand:
Investor sentiment is clearly fragile after the drop in all risky assets over the last several days. But the near-term impacts of this one-notch downgrade should be minimal for the US bond markets, in part because sentiment is so fragile.
[Easy Street Translation: Investors who own stocks are still a bit panicky after the stock market crashed on Thursday and seesawed up and down on Friday. But investors who own bonds probably won’t freak out because this downgrade is a relatively small one.]
We do not anticipate forced selling of US Treasuries from any significant investor base. Foreign central banks maintain a large share of their FX reserves in USTs because it is the deepest and most liquid bond market. This is unlikely to change due to a ratings downgrade. Mutual fund investment guidelines retain significant flexibility regarding the handling of this action. The US banking system should not be forced to sell as well because the Fed has issued a guideline noting no change in risk weights. Similarly, insurance companies are also unlikely to be forced to sell as the NAIC has already de-emphasized ratings for regulatory capital requirements.
[Easy Street Translation: Treasury bonds will probably stay relatively safe and no one will rush to sell massive quantities of them. Other countries always keep lots of U.S. Treasury bonds on hand, for instance, because there are always buyers and sellers for Treasuries – and that won’t change. Mutual funds probably won’t sell their Treasury bonds either; a lot of them have to keep AAA assets, but they can use their own discretion to basically ignore the downgrade. Banks won’t sell Treasuries because the Fed said this weekend that the downgrade basically doesn’t matter: Treasury bonds are no riskier as collateral than they were before. And finally, insurance companies won’t sell their Treasuries because their regulator doesn’t require AAA bonds to support the insurers.]
Haircuts in the repo market may rise but since haircuts or margins are meant to protect cash lenders from daily price fluctuations in the collateral, they are more likely to depend on changes in price volatility of Treasuries, rather than just a downgrade in itself.
[Easy Street Translation: One part of the market that might get complicated is the “repo market,” the market in which banks lend money to each other overnight to help each other settle their accounts. Banks use Treasury bonds as their collateral for that lending, and the downgrade of the U.S. may, of course, hit the value of bonds from the U.S. Treasury. Here’s a regular-person explanation of the repo markey by yours truly. Martin predicts that banks will care more about the price of Treasury bonds than their ratings.]
Similarly, in the derivatives market, most CSAs do not explicitly draw a link between the eligibility of US Treasuries as collateral and their AAA rating. In addition, given that major US banks are several notches below AAA, a single-notch downgrade should not lead to downgrades in the credit ratings of banks. Even if that were to occur, additional collateral requirements would be manageable in our view.
[Easy Street Translation: The derivatives market is the largest market in the world, with over $1.2 quadrillion of value, at least on paper. (Yes, quadrillion). Treasury bonds are collateral for derivatives too. The credit documents that govern what can be used as collateral for derivatives don’t require Treasuries to have an AAA rating. A lot of big US banks are already well below AAA-rated, so they probably won’t get downgraded just because the U.S. was downgraded. Even if the banks did get downgraded, they could easily pony up more collateral.]
What are the markets going to do this week?
Short answer: Almost everyone agrees that you should expect a short-term bloodbath, particularly on Monday, and particularly in the stock markets. The scale of the bloodbath may depend on which market you’re looking. Housing is likely to be the ugliest.
The Asia open Sunday evening and US Sunday morning is likely to be ugly. Stocks have the most to lose here, as risk assets are more sensitive to market perceptions and psychology. There’s a likelihood of extremely volatile Treasury markets and some forced selling, which could create an unprecedented trading range on Monday and the first days of the week.
Anyone who tells you they can precisely predict the trading outcome in this situation is exaggerating. There are too many unknowns to be sure about early trading this week, but I’m confident that these precepts (high volatility, limited but present forced selling, and a return to economics-based trading) will prevail.
Hilary Kramer goes out on a limb with a bold prediction:
We will have a morning sell-off and then calming words will come from the White House and then Bernanke later in the week. The rating downgrade could even be reversed this week. McGraw Hill could easily buckle to the pressure.
David Semmens points out that when a country gets downgraded, ratings agencies usually downgrade all its AAA companies to grade on the same curve. But S&P won’t be doing that with the four AAA rated U.S. companies – Exxon and Microsoft included.
Glossary: “Yields” are just a fancy word for interest rates. When Treasury yields – or interest rates- fall, it’s an indication that investors still really like Treasuries. If investors didn’t like Treasuries, they would demand higher interest rates – the same way that credit card companies raise your interest rate if you’re not likely to pay your bill on time. The connection here is that he housing market is pinned to the interest rates on Treasuries; so when Treasury rates are low, interest rates on mortgages are low too
Back to Semmens:
This action will not affect the four companies, Exxon, ADP, Johnson and Johnson and Microsoft’s AAA rating, although it will see a downward revision to the Government Sponsored Enterprises (GSE) Fannie and Freddie Mac. This is likely to place further pressure on the already weak US housing market, although the recent decline in treasury yields has seen available refinancing levels become increasingly attractive, with accessibility more of the question.
What happens over the long term?
Short answer: Let’s not kid ourselves; we look like the biggest flakes in the world. Investors in Treasury bonds and dollars are going to start seeing other people – or rather, other countries.
Glossary: Any rise in interest rates is measured not in percentage points, but in “basis points.” A basis point is just 1/100 of a percent. So there are 100 basis points in every percentage point. Now, a U.S. downgrade will probably make it more expensive for us to borrow; but how expensive? Look for the answer in basis points.
Here’s Ajay Rajadhyaksha, and we’ve added our Easy Street Language Emulator to help you translate:
Being the world’s reserve currency seems incongruous with a AA rating. The longer-term effects are driven primarily by whether markets eventually also downgrade the US. In that case, the biggest impact should be through the effect on the USD as a reserve currency.
[Easy Street Translation: It seems a little ridiculous for other central banks to stockpile dollars as their strongest protection when we’re not even a AAA-rated country any more. We should watch to see if the markets also “downgrade” the U.S. If they do, we’ll see the dollar take a big hit.]
Based on prior research, we believe that a one-notch downgrade would lead to an increase of 25bp in borrowing costs. But this is not a function of a specific rating action, but of the market downgrading the sovereign rating.
[Easy Street translation: Martin’s previous research showed that if the U.S. got downgraded by one notch, we’d pay an interest rate about 25 basis points – or 1/4 of one percent – higher than the one we were paying. That’s not S&P’s fault – that would just be the market telling us they don’t trust U.S. assets as much any more.]
A downgrade could increase diversification away from the USD. Foreign investors have supplied 30-40% of non-financial credit creation in the US over the past few years. An increase in the pace of diversification should be an economic drag, as domestic savings would have to rise to pick up the slack.
[Easy Street Translation: Investors who hold dollars may start moving away from them and into other currencies. About 30% to 40% of our credit creation in the U.S. – outside of banks, of course – has come from foreign investors. If foreign investors start dropping the dollar, Americans would have to save more money to make up the difference. But we know that the U.S. savings rate is near zero, so that seems unlikely.]
What about the debt ceiling deal that we just signed before Congress went on vacation? Did that accomplish nothing?
Short answer: Despite the sturm und drang, it didn’t do very much.
The debt ceiling deal did not include the tough choices needed (see ‘US Debt Ceiling Deal: Not Good Enough’, dated Aug 1, 2011). It has two major problems:
It does not put the US on a sustainable fiscal path, since it does not stabilize the debt/GDP ratio over the next decade. The amount of reduction it targets ($2.1-2.4tn in two stages) was half the $4-5tn in total deficit reduction we believe is necessary to stabilize the debt/GDP ratio.
It does not make structural reforms to either entitlements or taxes. Instead, the deal focused mainly on cuts to discretionary spending, including defense. The problem is that these cuts can be more easily overturned by future Congresses than, say, a major tax reform overhaul.
What should we watch for next?
Short answer: The fireworks in the markets will attract attention, but that may be a distraction. The Fed’s Open Market Committee, or FOMC, meets on Tuesday. The Fed is our national arbiter of interest rates, and over the past few years it has also had a strong hold on the future of the economy. This Tuesday meeting may be one of the most important in its history.
Update: I updated the name of the Barclays Capital analyst.
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