On Friday August 5th 2011, the rating agency Standard & Poor’s lowered the USA’s AAA credit rating for the first time since granting it in 1917. S&P dropped the US credit rating one notch to AA+. There are now eighteen countries and seven global corporations with a better credit rating than that of the US government1.
BofA Merrill Lynch Global Research, titled, “BofA ML Equity Strategy: Global Cross Asset Strategy – The BofA-ML house view on the US credit rating downgrade” said that there would be likely more shocks to come.
S&P retained a negative outlook and the other major rating agencies have negative outlooks.
If the recently created deficit commission does not come up with tax and entitlement reforms later this year, BofA Merrill Lynch expect S&P to downgrade further to AA and for Fitch and Moody’s to do their first downgrade. “Unfortunately the initial reaction from Washington has been one of finger-pointing and questioning S&P decision and methodology. This implies that policy makers will not use this as a wake-up call to put a long term deficit plan in place. We will watch for the performance of the $27billion in Treasury auctions scheduled for this week. In our base case scenario, these auctions should be met with adequate demand but it could be a volatile process,” it said.
“The S&P downgrade runs the risk of sparking a short-term liquidity event in the market, and we would expect the Fed to respond if needed. The Fed could potentially dust-off some of the credit facilities it introduced at the height of the financial crisis. We are watching the repo market and redemptions from money market funds. All else equal, this shock presents another reason for the Fed to stay accommodative for longer. Our view remains that the first rate hikes will not be until Q1 2013 or later,” it said.
“Global central banks will respond aggressively too While the downgrade puts a dent in the US dollar as a reserve currency, creating significant long-run risks, we do not expect emerging market central banks to rush to unwind their dollar holdings. In the face of a weakening global economy, we expect foreign governments to continue resist weakness in the dollar as part of their export-led growth strategy. With the rating downgrade coming on the heels of the intensifying crisis in Europe and mounting signs of a global slowdown, it is reasonable to assume that global central banks will respond aggressively to calm markets by ensuring ample liquidity is supplied and in some instances easing monetary stance. This was already evidenced last week by the decision by the Bank of Japan to intervene to support the USD and to increase the size of QE, the easing of liquidity by the Swiss National Bank, and the unexpected interest rate cut by the central bank of Turkey. This means that the inversion of the yield curves in some countries with relatively high levels of policy rates may continue. Meanwhile, the market will likely continue to focus on the ECB, in particular with respect to whether the latest fiscal policy announcement by Italy will be sufficient persuade it to begin to buy Italian and Spanish government bonds. If this were to materialize in the coming week, it will help provide at least a short-term boost to the EUR.
Negative implications for mortgages and real estate Longer term, the negative outlook for US Treasury debt has negative implications for the mortgage market and, by extension, the fragile US housing market, since over 90% of US mortgages currently are financed via agency MBS. The private label securitization market remains shut and prospects for re-opening it are bleak due to ongoing regulatory credit tightening. With home prices still trending downward, ratings pressure on the government raises the risk that it is forced to scale back its support of housing and that the downward home price trend is exacerbated by further contraction of credit.
Ultimately, the level of rates is a function of fundamentals of the economy, Fed policy and the supply-demand outlook for duration. The downgrade further undermines confidence and credibility in the already fragile economy. This should keep the Fed accommodative for longer. We expect a near term “risk-off” move, which should benefit cash and front end and intermediate Treasuries. We do expect 10y and 30y rates to rise modestly, due to an increase in term premiums. Our measure of 10year term premium is close to zero and should increase to price in the longer term erosion of the safe-haven asset quality of US Treasuries. Thus we expect a steeper curve. Note that the Treasury auctions $72billion in paper this week, and the auction process could be volatile. We also expect Treasuries to underperform swaps in the long end resulting in tighter swap spreads and a flatter spread curve. GSE debt should also widen to Treasuries in an illiquid risk-off environment, where the implicit government backing could be viewed as being less desirable.
The downgrade will no doubt weigh further on the already very negative sentiment towards the USD and accelerate the pace of reserve diversification from the USD. However, the short-term outlook for the USD depends critically on the reaction of risky assets to the S&P’s decision. It is conceivable that if the recent sell-off of risky assets were to continue, the USD may even strengthen, at least against high beta EM and commodity currencies. The USD has emerged as a countercyclical currency in the past decade, that is independent of its reserve currency status, and a global slowdown will bring with it some clear benefits for the greenback, in terms of trade improvement, narrowing interest rate differential.
In the short run, gold should be the main winner of the credit quality downgrade and prices should easily exceed $1700/oz.
Should the credit downgrade ultimately dampen consumer and business confidence enough to result in a mild recession, we would expect to see Brent crude oil prices briefly breaking below$80/bbl.
Still, in the absence of more fiscal stimulus, we believe that monetary policy will be a key channel of adjustment. With gold prices already moving higher, a recession-driven pullback in Brent crude oil due to economic weakness could be short-lived. Thus, we still lean towards maintaining our average Brent forecast of $114/bbl for next year, despite the growing downside risks.