US Rating Cut to AA+ Negative by S&P for First Time
August 05, 2011, US had its AAA credit rating downgraded for the first time by Standard & Poor’s. The rating agency also kept the outlook at “negative.” The downgrade reflects S&P’s opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics, S&P said in a statement yesterday.
Moody’s and Fitch Ratings affirmed their AAA credit ratings on Aug. 2, the day President Barack Obama signed a bill that ended the debt-ceiling debated. Moody’s and Fitch also said that downgrades were possible if lawmakers fail to enact debt reduction measures and the economy weakens.
Market Sentiment:
Ø The rating downgrade is not a big surprise to the market.
Ø In the previous note sent on July 28, I have suggested that there is a 50% probability of 1-notch, 20% probability more than 1-notch, 30% on hold.
Ø Meanwhile, Standard & Poor’s warned on July 14 that it would reduce the rating in the absence of a “credible” plan to lower deficits even if the nation’s USD14.3trn debt limit was lifted.
Ø Major indices only saw minor corrections --- SP500 -0.6&, Dow +0.54%, Nasdaq -0.94%. VIX stayed at >30 level, but only +1.07% to 32 during the trading session.
Debt /Currency Market:
Ø Even with the specter of a downgrade, investors’ demand for USTs has surged as investors saw few alternatives to the traditional refuge during times of risk as concern increased global growth is slowing and Europe’s sovereign debt crisis is spreading.
Ø Over the past 5 days, 2yr UST yield dropped 7bps to 0.288% and 10 yr down 24bp TO 2.558%.
Ø Historically, UST yields on average are 70bp less than the rest of the world’s sovereign debt markets.
Ø In the medium term, the US credit-rating cut would likely raise the nation’s borrowing costs by increasing UST yields by 60-70bp.
Ø DXY index lost 0.7% to 74.598 overnight. As of Friday, it has lost 13.36% annualized since January 07.
Ø No doubt, the rating cut will hurt USD ‘s status as the only reserve currency.
Ø According to IMF, the USD’s portion of global FX reserves dropped to 60.7% in the period ended March 31, from a peak of 72.7% percent in 2001.
Macro Economy Impact/Fed Meeting Preview
Ø The action could still hurt the US economy over time by increasing the cost of mortgages and loans, of which their interest rates are referred to USTs.
Ø JPMorgan estimated that a downgrade would raise the nation’s borrowing costs by USD100bn a year. As a reference, US spent USD414bn on interest expense in fiscal 2010, or 2.7% GDP, according to Treasury Department data.
Ø This is certainly a negative new to US growth prospect, given that major Wall Street brokerage houses have the economic forecast has been revised to show real GDP growth of 1.5% saar this quarter and an average of only 2.0% over the coming year, down from 3-3.5%.
Ø Looking forward, the US expansion will be trapped by an ongoing tension between cyclical lift and structural drags in the aftermath of a damaging financial crisis and deficit cut.
Ø The Fed is almost surely revising down its growth forecast as well.
Ø The Fed will likely respond by altering next Tuesday’s policy statement to indicate that the current policy of reinvesting principal payments will be maintained for an extended period.
Ø In addition, the reinvestment policy probably will extend the average maturity of Fed holdings.
Ø There is almost no chance that the Fed will begin another round of large-scale asset purchases, however, in my own views.
Global Equity Markets Outlook
Ø Looking back, a global slump has erased +USD4.5trn from the value of equities worldwide since July 26.
Ø The S&P 500 erased its gain for 2011 this week and is now down about 4.6% for the year after slumping 11% since July 22 in its worst plunge since the bull market began in 2009.
Ø In contrast, Wall Street has never been more sure that stocks will rally in 2011, even as LTE data on manufacturing and service industries fueled concern that the nation will slip back into a recession.
Ø Chief strategists at 13 banks from Barclays to UBS see S&P 500 surging 17% through Dec. 31, according to the average estimate in a Bloomberg survey. Their projection that the index will reach 1401 hasn’t budged in four weeks.
Ø For our regional and China markets, the risk is more on an extended slow-down in the DM countries at this stage.
Ø According to DB, if assuming US/EU GDP growth is revised down 1%, it would tend to reduce Chinese export growth by 7% and reduce Chinese GDP growth by 1%. This result is based on historical correlation.
Ø In addition, the US/EU combined account for 40% of global demand for oil and 20-30% for metals. Thus, even if Chinese demand remains constant, a slowdown in US/EU growth could put significant downward pressure on these commodity prices, thereby reducing the profitability of Chinese producers in these sectors.
Ø As a result, we should UW or avoid the export-related sector and industry metals sectors.
A Quick Summary over US Debt Talk Crisis
I. Quick Reviews over the Past 48 Hours
The political gridlock over the US debt ceiling continues to take center stage even though there was again little progress towards a deal over the last 48 hours.
Ø Speaker Boehner's plan suffered a blow after the CBO said that it would only achieve USD851bn in deficit savings over the next 10 years from the USD1.2trn previously thought.
Ø There is growing skepticism amongst House conservatives that the cuts proposed in Boehner's plan are inadequate.
Ø Republicans are now being forced to re-write Boehner's bill further delaying progress.
There is also speculation that a failed vote on the House measure could have (or could still) rock financial markets in a manner similar to the way that the first failed vote on the TARP program did in the autumn of 2008.
II. Risk Markets Reaction
Market participants are becoming increasingly anxious as the August 2 "deadline" approaches, although even on that front there are conflicting reports indicating that may not be quite the "hard" deadline that the US Treasury has made it out to be. Some reports indicate that Treasury actually has enough cash on hand to get it to August 10.
Overnight, I saw a broad-based risk reduction --- the sell-off in gold, the sell-off in equities, the rally in the USD, and the flattening in UST yield curve.
Ø Equities: SPX drops 27 to close 1305 (-2.03%). The DOW closes down 199 at 12303 (-1.59%). The NASDAQ closes down 2765 (-2.65%). 10 subsectors were in red with tech and industrials the worst performing.
Ø Volatility: The VIX up another 2.75 vols t to 22.98, testing June 16 highs and now up 30% since Friday close
Ø Commodities: GOLD Down -0.17 at 1,616.50; OIL Down -2.40 at 97.20
Ø Credit: 5Y US CDS hit a new 52week high
III. Latest Updates on US Debt Ceiling Talk
Hopefully, the 200 Dow point risk purge yesterday will make US politicians on both sides of the aisle think twice about their delaying tactics that seem to be more about passing debt ceiling legislation that will carry through 2012 (Obama's desire) or not (Boehner's wish) as opposed to the total level of spending cuts/revenue raising.
House Democrats are becoming increasingly supportive of the idea that President Obama should invoke the 14th amendment to resolve the stand-off. For those unfamiliar with the amendment, here are the pertinent details: “The validity of the public debt of the United States, authorized by law, including debts incurred for payments of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.”
Former President Bill Clinton has come out and said that this is what he would do if he were still President.
More Importantly, S&P said on July 14 that the risk of a downgrade was 50-50 within the next three months, lacking the required long term debt reduction plans.
IV. Possible Impact over US Ratings
In terms of the impact on the AAA rating, S&P has said that if an agreement of about USD4trn is reached and maintained throughout the decade, the AAA rating will be affirmed. However, given all the discussions that we've seen so far, it seems that the size of the deal will likely fall short of that required to avoid a S&P downgrade.
Ø So far, based on the S&P’s precondition on downgrading (S&P wants to see a $4trn plan), I think 50% probability of 1-notch, 20% probability more than 1-notch, 30% on hold.
Ø Moody's and Fitch probably hold off on a downgrade of USA for now.
Ø If the US Sovereign rating was cut by one notch, S&P would downgrade the debt ratings of the GSEs, AAA rated US insurance groups, and any AAA rated entities that are directly linked to the sovereign rating. Clearinghouses' ratings would also be downgraded.
n In this scenario the rating impact on financial institutions will likely be fairly benign as the market does not expect additional downgrades immediately in the financial services industry.
Ø More than 1 would be a problem for US bank bond holders and money markets via repo counterparties.
Ø The problem comes if the US AAA rating is downgraded to Selective Default.
n In this scenario, the market expects a systemic market disruption to follow the revision to 'SD', which would have a significant impact on ratings in the financial sector.
n If there sees a selective default occurs, but without a systemic market disruption, the impact on financial institutions' ratings would be less severe.
V. Possible Impact over global economies and financial markets
Ø Market Confidence: The markets are being weighed down by a continued reduction in confidence over DC debt wrangling with the economy seen as already vulnerable.
n Indeed, the anticipated 2H recovery from the Q2 soft patch is becoming cloudy at best and mugged by plummeting confidence at worst.
Ø Economic Consequence: A failure to raise the debt ceiling in August would certainly have substantial negative economic consequences.
n The seasonal pattern of government receipts suggests that only in October would the government be forced into defaulting on its more popular obligations.
n That recent tax receipts have been stronger than expected means that an original deadline of August 2 can probably be extended into mid August before receipts start becoming insufficient to meet the Federal government's existing commitments.
n Further there are other maneuvers to keep payments flowing such as paying the Fed IOUs in lieu of coupons (as California did with paychecks) on their USD1.6trn UST holdings
n This could mean that if attempts to get a near term deal fail, the standoff could be extended for some time.
n A longer deadline could lead to more substantive deficit reduction which would ward off any downgrade which really is the fear as default will not happen.
Ø With respect to the Asian economies, Taiwan looks to be highly vulnerable on each count, while India is the least vulnerable on lack of integration into the global economy and financial system
n Growth Risk (most to least) --- Taiwan > Korea > HK > Sing > Malaysia > Thailand > China > Phil > Indo> India
VI. Risk Market Implications
Ø But markets won't allow it, as this basically implies that risk-free asset no longer risk-free, and the assumptions to all the asset valuation models are to be rewritten.
Ø If we see a downgrade, 10yr UST is likely to be sold off to 3.25% area.
Ø USD could continue to sell-off in response to the Debt talk. Given many non-US institutions continue to need USD, thus should the global slowdown continue and funding become tight, I suspect USD has to trade up vs. majors.
Ø In the near term, Investors better stick with the safe, low beta, non-financials.
