US Credit Rating Downgrade: Impact on financial and commodities markets
US Credit Rating downgrade: Impact assessment
The Rating Downgrade
Standard & Poor’s (S&P) downgrade of the US sovereign credit long-term rating by a single notch on Friday evening, 5th August 2011, after US markets closed has been the topic for the last 24 hours. The rating agency downgraded the US from its coveted triple A (AAA) rating to a double A plus (AA+) rating with a negative outlook, the first ever downgrade of US in the history of the country. It left the short term rating intact but left room open to drop the rating by another notch in the next 2 years if the primary reasons for the initial downgrade were not addressed.
While S&P initial discussion focused on projected revenue shortfall and its impact on the Debt to GDP ratio, the rational changed to a political stance once the US treasury pointed out that the rating agency had used the wrong baseline in its analysis (the 2 trillion dollar mistake that changed the world?). In contrast two major rating agencies, Fitch and Moody’s, had confirmed the soundness of the US’s AAA rating following the increase in the US debt ceiling last week.
S&P cited the following reasons for their decision to downgrade:
- A weak political environment where Congress and the US Administration are less likely to work together for a longer term resolution of the debt issue. The last minute resolution of the near debt default situation through the raising of the credit ceiling and deficit reduction through discretionary spending cuts speaks volumes of the lack of cooperation between the political parties.
- The fact that the recent bill passed to address the debt problem did not take any significant measure to increase revenues (through tax increases).
- And a rising debt burden (S&P have projected the end of year 2011 debt-to-GDP ratio to be at 74% growing in their worst case scenario to 101% by 2021).
The result could be a potential worsening trend of an already high debt-to-GDP ratio (a critical indicator of economic health) over the coming years. The fact that the US economy is growing at a much slower rate than expected as most recently indicated by the poor outlook and results of US jobs data together with a weak political will to reduce the debt deficit through, increased taxation, a permanent lapse of tax cuts that are due to expire end 2012, other methods to enhance revenues and more spending cuts (particularly to entitlements such as Medicare), is a major cause for concern. Republicans and Democrats decisions have been more influenced by political motivations than actual effective governing because of the election year ahead. This is cited as a major concern for S&P as they believe that not enough has been done with the recent debt reduction bill (Budget Control Act Amendment of 2011) to stabilize the US deficit situation, nor is it likely to be done in the near future, and that there is a very real fear of a recurrence of the near default situation experienced last week.
The financial impact of the US credit rating downgrade
The move is expected to have far reaching and long term impacts, both politically as well as economically, for the global economy and will certainly increase short term volatility in the financial markets over the next 2 – 4 weeks.
In the long term, if other rating agencies follow suit and challenge credit worthiness of the US, popular opinion suggests that the status of the dollar as the primary reserve currency will come under a fresh challenge. The actual likelihood of this happening is low and no one does a better job of presenting this argument than Professor Pettis at China Watch. In essence there is a cost associated with housing a global reserve currency and given the environment in Europe, Japan and China, no other country in the world is in a position to do so. Despite its problems and issues, the US dollar still remains the primary candidate for a globally accepted medium of exchange. While central banks would carry on buying gold, there is not going to be an immediate reduction in purchase of US treasuries, despite the rating cut.
In the short run while US regulators have stated that there will be no regulatory capital impact on holding US treasuries, European and Asian regulators still have to issue an opinion on this event. The most likely reaction given what will happen on Monday is that ECB, Bank of Japan and a host of other regulators are likely to toe the line to avoid further roiling markets and increasing capital requirements for domestic banks given the share of US treasuries held within bank capital internationally. A reading of the Basel II regulations also indicates that as long as two of the three rating agencies re-affirm the ratings of an issuer, form a capital charge point of view, the higher rating can prevail, unless otherwise indicated by the local regulatory authority.
The only exceptions would be China (given the impact on regulatory capital unlikely). At this stage no major central bank would like to feed volatility or wide scale panic or a reduction in perceived capital adequacy.
A number of analysts believe that markets had already priced this event. Rumors of the possibility of just such a downgrade following S&P’s mid-July warning and the last minute debt deal reached by the US Congress and political parties were rife in the media and could have been one of the factors in the increased volatility seen in the markets last week. Though the likelihood of a downgrade was being considered, many analysts had believed its actualization unlikely given the potentially adverse impact such a move could have on the US and global economy.
Still come Monday a few things will happen that will push markets to be more volatile. The first is a spike in repo rates combined with the expected flight to safety. Repo rates play an important role in determining the final financing cost of a speculative transaction (or trade) and combined with the flight to safety effect will lead to a higher than average unwinding of speculative trades across equity, currencies and commodities markets. And while banks may remain untouched on account of capital requirements, Hedge funds may have no other options but to unwind their trades when faced with rising volatility and rising financing costs.
The primary victims would be the Australian dollar, crude oil and other industrial commodities. The primary beneficiaries would be precious metals and in a perverse twist of fate, US treasuries, since despite the downgrade, they will still remain the preferred flight to safety capital haven. The world still has to define a viable alternative and while Gold and Silver come to mind, at current price levels and volatility, they may preserve relative value but cannot assure capital protection.
The challenge investors’ face will be in balancing probabilities of a slow down against the relative value argument. If the rating downgrade pushes the US towards a second recession (unlikely) and leads to a global slowdown, markets will head south. If the rating downgrade doesn’t lead to a US recession but a further weakening of the US dollar (possible), after an initial fall commodity prices should rise since producers of the same commodities would now require more dollars on a relative value basis.
The primary defender in the double-dip-recession-unlikely camp is Warren Buffet who has positioned himself to bet heavily against the likelihood of a double dip. Interestingly enough if the dollar does fall as projected and Congress gets its act together to quickly work through (unlikely?) the deficit reduction plan and slashes the mandated 4 trillion US dollars from future US spending, in the long run the S&P rating downgrade may be the very event that would push the US economy in the right direction.
While crude oil may dip further initially, the rating downgrade’ short term negative impact (September to December) on the consumption of crude oil, petrochemical products and other derivatives is likely to be minimal. Credit card rates, mortgage payments and other consumer interest rate costs are likely to be managed at least in the near term given their importance in an election year. Remember that this is Hurricane season in the Gulf of Mexico, turnaround season for crude oil refineries and the winter (Oct-Feb) is just around the corner. And if the Fed rolls out QE3 as planned (which they will) it will fuel commodity inflation.
The rating downgrade: Political fallout
As expected the initial reaction has been one of outrage. Some analysts have gone out and held S&P responsible for the very situation that resulted in the downgrade. If only the rating agencies had done their job with rating Special Purpose Vehicles (SPV), there wouldn’t have been a financial crisis and a need for QE1, QE2 and now QE3. The last minute basic mathematical error by the S&P has also not helped.
There is also debate around S&P credentials and mandate to rate the US political system and use that as a basis for a decision with financial implications which is the reason why some analysts have labeled this as a political event. To be fair to S&P the rating methodology does include political risk within the framework for evaluating country risk. The events leading up to the August 2 settlement between the Congress and the Senate and the last minute high wire act may be acceptable for a lesser nation but are certainly not suitable for the host and the most influential player within the global financial system. A few years ago before the Euro imploded, an event like this (the high wire act) would be unthinkable and China wouldn’t be the only voice of outrage.
There is also an issue of national pride. For the last 65 years the world has looked towards the US as the final and ultimate safe haven. By removing the US from the list of 17 countries that retain their AAA ratings, S&P has gone ahead and shaken the assumption that from a governance point of view things are in order. Looking further ahead the biggest fallout will be suffered by the re-election campaign of the sitting president, post the August 2nd wrangling, the unemployment picture, rising rates and the threats of a double dip recession . Second in line would be the Tea party though if this leads to their re-capturing the Whitehouse in November 2012 they really wouldn’t mind the short term damage. While S&P has squarely laid the blame for the rating cut on the take-no-prisoners-mindset of the GOP, the message passing through media is more ambiguous. It will be ironical to see Republican candidates use the same playbook created by President Clinton and his campaign team to unseat a victorious incumbent president after the first Gulf war. The rating downgrade would simply give them more ammunition.
(About the authors: Jawwad Farid and Agnes Paul are both Fellow Society of Actuaries (FSA) and part of the commodities analyst group at Alchemy Technologies. They can be reached at [email protected] and [email protected] respectively)