S&P Downgrade: True to their word
Harbour Special Commentary: In this piece Harbour Asset Management looks at what the downgrade of the US credit rating means to markets and investors.
Monday, August 8th 2011, 3:06PM
by Harbour Asset Management
For most of July the political focus on revising the debt ceiling has been a red herring.
The real driver of the rapid fall in bond yields and equity market weakness has been worries that the US and European economies will have slow growth for many years as they work off the pre GFC excesses. Alongside recent weak US data, the debt ceiling revision has reminded markets that policymakers are running out of tools to continually fuel the recovery themselves.
At one level, S&P downgrading US debt from AAA makes less sense as the US only issues domestic currency debt. It is highly unlikely to ever need to default on US dollar debt as technically the US can just print money to inflate anyway the value of its old debts - a benefit of not being "trapped" in a currency union. Furthermore, as the world's current reserve currency, the US is in the unique position in that the world has been a natural holder of US debt.
We think that the S&P rating decision reflects an opinion that they now view the US to be blatantly abusing that privileged position. Clearly the largest holder of US debt, China, agrees with S&P's statements over the weekend. It was most disappointing that US politicians used the review of the debt ceiling for political grandstanding, illustrating a lack of seriousness about the need for a clear plan and united front to sort things out and establish a sustainable path for US debt reduction. The S&P decision can be seen as a direct response to a shambolic US political system in need of a wakeup. They have certainly picked a fight, but a fight that was forewarned in April when they said "the negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years. The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012."
In the medium to long term a debt downgrade should result in higher US bond yields and lower US currency.
But in the short term historic evidence provides alternative evidence. For instance, when in May 1998, S&P knocked Belgium, Italy and Spain from AAA to AA their 10-year rates barely moved over the next week and a week after S&P took Ireland's AAA rating away in March 2009, 10-year rates in that country fell 0.18 percentage points.
In addition over this last weekend U.S. banking regulators also moved quickly to reinforce the security of Treasury debt after S&P announced the downgrade Friday night. Regulators said they would continue to view Treasuries as a zero-risk investment and would not force banks to hold more capital against their Treasury investments.
In terms of the US dollar the implications are also ambiguous. In the first instance, there is no obvious candidate to replace the US as the reserve currency - they are all either too close to the problems in the euro, too small, or not developed enough. However, in the medium term if US growth prospects are impacted (which we expect markets will expect) it is highly likely that expectations will increase for the US Federal Reserve to maintain a looser monetary stance. As expectations build for relatively looser US monetary policy we could expect further US dollar weakness.
A second round effect then could be to support the US dollar value of commodity prices which otherwise may fall back because of fears of slower global growth.
The outlook for commodity prices is mixed, as Chinese growth remains firmer than expected, but investors view commodities as a risk trade which seems likely to be wound back.
On the margin, the downgrade may underline the relative fiscal prudence in New Zealand and Australia. The outlook for NZ and Australian Government bonds and credit remains reasonable. In New Zealand, our bonds yield 200 basis points over the 2.50% yield on 10 year US Treasuries. This yield will continue to look good to Asian Investors. Although we think NZ government bond yields will rise as the New Zealand economy recovers, it may not be a journey very far or fast for now.
In terms of New Zealand equities, our base case of a firmer economy is largely unchallenged by recent developments. Most of our growth impetus is coming from near term Rugby World Cup, followed by almost $15bn on insurance payments to rebuild Christchurch. Our equity portfolios have shunned bank exposures - which remain most exposed to the tail risks in Europe and the US. We have a significant hedge into New Zealand dollars in our portfolios, and we are most overweight New Zealand growth opportunities, the healthcare sector and resource based exposures.
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