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Conference Call Summary: Eurozone Debt Crisis and US Ratings Downgrade
Standard & Poor's downgrade of the US debt rating and increased tension in the Eurozone debt crisis have significantly increased downside risks and the probability of a bigger market correction in the near term. The downgrade, while not unexpected and subject to extra scrutiny because of an initial calculation error, amplifies already rising sovereign risk concerns in Europe. In fact, as our strategists argue below, the impact of the downgrade may be more acute in Europe than in the US by bringing the "end game" forward. Those risks are a further headwind to a slowing global economy, one that's likely to be buffeted by more fiscal tightening in 2012 brought on by the debt crises. With investors in de-risking mode and confidence fragile, failure to provide a more globally coordinated policy response could prove to be a tipping point for the markets, even though a recession is not our base case for next year.
Expect more volatility, while risk free assets are likely to benefit as risky assets come under additional stress. A paradoxical consequence of the rating downgrade is that Treasuries and the USD are likely to rally, at least in the near term, as investors assess the consequences of these latest developments. The same should be true for safe haven currencies (JPY and CHF), as well as some "true" AAA assets in the securitized product space that are not linked to Treasuries. Even if a more significant policy response is forthcoming, such as the European Central Bank (ECB) purchasing Italy sovereign bonds through the Securities Market Programme (SMP) to buy time to ratchet up the European Financial Stability Facility (EFSF) mechanism, investor skepticism about the efficacy of such efforts is likely to limit the near-term upside for risky assets from current levels.
Eurozone Debt Crisis and US Ratings Downgrade
Elga Bartsch Europe Economics
The euro area sovereign debt crisis is likely to escalate further. The downgrade of US government debt will likely add to the existing, severe pressure on the euro area periphery. The additional pressure – which my colleague Arnaud Mares will outline in more detail below – comes at an inopportune moment when the euro area is already experiencing an escalation of its sovereign debt crisis – an escalation that is due to half-hearted policy measures and to rising concerns about a slowdown in economic growth.
Markets remain on edge after the July 21 summit. The agreement reached by euro area governments at the July 21 summit to introduce precautionary credit lines, bond purchases in secondary markets and bank recapitalizations to the existing rescue mechanism clearly failed to calm markets. The implementation time lag, which means that the new features will only be up and running in September, unsettled investors who fret about the parliamentary approval process.
Likewise, Thursday’s ECB decision to reopen the Securities Market Program and start buying Portuguese and Irish government bonds again seem to have backfired. Not only was the policy action taken by the ECB viewed as "too little, too late" by many market participants, but the decision also revealed a deep rift in the ECB Governing Council. Reportedly, the two German Council Members and two Benelux representatives were against reopening the SMP. The market perception that the SMP does not have the full, undivided support of the Governing Council could undermine the program’s effectiveness, also should the ECB decide to broaden the purchase program to bigger euro-area bond markets, such as Italian BTPs for instance.
More fundamentally, the controversy in the Governing Council raises an important question about the effectiveness of the ECB’s intervention in government bond markets. Under the enhanced rescue mechanism (see Euroland Economics: A Step Forward, But Not a Big Leap, July 22, 2011), bond purchases by the rescue fund would need to be sanctioned by a unanimous decision of all euro area finance ministers. The ECB decision to buy bonds, by contrast, does not require unanimity, as we have already seen last year. True, given its full operational independence enshrined in the European Treaty, the ECB can push ahead with its bond purchases. But, it would do so at the risk of undermining public support for the euro in the core countries. Hence, fending off a bond market meltdown in the non-core countries in the short-term could come at the cost of a rising risk of EMU breakup in the long term.
The escalating sovereign debt crisis and its spillover effects into bank funding markets add to the serious headwinds the euro area economy is already facing. Back in early April, we cut our 2012 GDP forecast to a below consensus 1.2% based on our projection that euro area growth would slow markedly in the second half of this year. Recent developments suggest to us that we might still be too optimistic on the growth outlook. Instead of the euro area economy growing at stall-speed over the winter quarters, stagnation, if not an outright contraction, might actually be more likely. Against such a backdrop, the next ECB interest rate decision could also be a cut rather than the hike our current forecast shows. That said, the ECB’s August press conference still sent a strong signal that, at least for now, the Bank remains in tightening mode.
Arnaud Mares Sovereign Economics
We focus on the two key take-aways from the downgrade. Prior to the ratings downgrade by S&P, we had thought the rating agencies would err on the side of caution and that a downgrade was less likely than the market expected. In light of the downgrade, there are two main take-aways, one for the US, one for Europe.
For the US, what is the meaning of a downgrade from AAA to AA? It does create higher risks for creditors, but not necessarily in the form of default.
A downgrade from AAA to AA does not imply a meaningfully higher risk of default, as we have outlined in the past few weeks. Based on Moody's calibration of the expected default at these levels, the probability of default over a 10-year horizon is 0.0% at Aaa and 0.1% at Aa1 (equivalent of AA+). This is a theoretical calculation because there is no historical data of sovereign default at these rating levels.
What this means is that the rating agencies cannot measure with any degree of accuracy the difference in credit risk between a AAA and a AA sovereign. What they are measuring and reflecting in their ratings at this end of the scale is the intensity of the conflict between creditors of
Eurozone Debt Crisis and US Ratings Downgrade
Elga Bartsch Europe Economics
The euro area sovereign debt crisis is likely to escalate further. The downgrade of US government debt will likely add to the existing, severe pressure on the euro area periphery. The additional pressure – which my colleague Arnaud Mares will outline in more detail below – comes at an inopportune moment when the euro area is already experiencing an escalation of its sovereign debt crisis – an escalation that is due to half-hearted policy measures and to rising concerns about a slowdown in economic growth.
Markets remain on edge after the July 21 summit. The agreement reached by euro area governments at the July 21 summit to introduce precautionary credit lines, bond purchases in secondary markets and bank recapitalizations to the existing rescue mechanism clearly failed to calm markets. The implementation time lag, which means that the new features will only be up and running in September, unsettled investors who fret about the parliamentary approval process.
Likewise, Thursday’s ECB decision to reopen the Securities Market Program and start buying Portuguese and Irish government bonds again seem to have backfired. Not only was the policy action taken by the ECB viewed as "too little, too late" by many market participants, but the decision also revealed a deep rift in the ECB Governing Council. Reportedly, the two German Council Members and two Benelux representatives were against reopening the SMP. The market perception that the SMP does not have the full, undivided support of the Governing Council could undermine the program’s effectiveness, also should the ECB decide to broaden the purchase program to bigger euro-area bond markets, such as Italian BTPs for instance.
More fundamentally, the controversy in the Governing Council raises an important question about the effectiveness of the ECB’s intervention in government bond markets. Under the enhanced rescue mechanism (see Euroland Economics: A Step Forward, But Not a Big Leap, July 22, 2011), bond purchases by the rescue fund would need to be sanctioned by a unanimous decision of all euro area finance ministers. The ECB decision to buy bonds, by contrast, does not require unanimity, as we have already seen last year. True, given its full operational independence enshrined in the European Treaty, the ECB can push ahead with its bond purchases. But, it would do so at the risk of undermining public support for the euro in the core countries. Hence, fending off a bond market meltdown in the non-core countries in the short-term could come at the cost of a rising risk of EMU breakup in the long term.
The escalating sovereign debt crisis and its spillover effects into bank funding markets add to the serious headwinds the euro area economy is already facing. Back in early April, we cut our 2012 GDP forecast to a below consensus 1.2% based on our projection that euro area growth would slow markedly in the second half of this year. Recent developments suggest to us that we might still be too optimistic on the growth outlook. Instead of the euro area economy growing at stall-speed over the winter quarters, stagnation, if not an outright contraction, might actually be more likely. Against such a backdrop, the next ECB interest rate decision could also be a cut rather than the hike our current forecast shows. That said, the ECB’s August press conference still sent a strong signal that, at least for now, the Bank remains in tightening mode.
Arnaud Mares Sovereign Economics
We focus on the two key take-aways from the downgrade. Prior to the ratings downgrade by S&P, we had thought the rating agencies would err on the side of caution and that a downgrade was less likely than the market expected. In light of the downgrade, there are two main take-aways, one for the US, one for Europe.
For the US, what is the meaning of a downgrade from AAA to AA? It does create higher risks for creditors, but not necessarily in the form of default.
A downgrade from AAA to AA does not imply a meaningfully higher risk of default, as we have outlined in the past few weeks. Based on Moody's calibration of the expected default at these levels, the probability of default over a 10-year horizon is 0.0% at Aaa and 0.1% at Aa1 (equivalent of AA+). This is a theoretical calculation because there is no historical data of sovereign default at these rating levels.
What this means is that the rating agencies cannot measure with any degree of accuracy the difference in credit risk between a AAA and a AA sovereign. What they are measuring and reflecting in their ratings at this end of the scale is the intensity of the conflict between creditors of
governments against other stakeholders that also have a claim on the government’s resources (i.e., the taxpayers and the recipients of public spending, ranging from government employees to contractors and suppliers and beneficiaries of entitlements and other social expenditure, etc.).
Even if this conflict were to be resolved against the interests of the creditors, this does not necessarily mean default, and resolution is indeed extraordinarily unlikely to take this form in a large country with fiat money. There are other ways to inflict losses on creditors that are considerably more likely because they’re less damaging to society and the economy and, unlike default, have been used repeatedly and successfully in the past, including financial repression and monetisation of the debt and eventually inflation.
From a fundamental perspective, the main lasting effect of Standard & Poor's downgrade ought to be to a greater market focus on these outcomes.
The second take-away, paradoxically, is that the downgrade of the US government may have more relevance for Europe than for the US. The reason is that a downgrade of the US government to the AA range raises legitimate questions as to whether European governments will remain rated AAA. In particular, those with vulnerable public finances (UK) and especially governments with a limited track record on debt consolidation and no absolute control over their central bank (France).
The focus on France will necessarily intensify also as a consequence of the likelihood that Italy and Spain are downgraded by rating agencies in the next six weeks or so. Downgrading Italy and Spain would “free up” space in the upper reaches of the AA range and, given that rating agencies rate on a comparative basis, would feed market expectations that they will fill this opened up space by downgrading France. I remain skeptical, based on the methodologies published by the rating agencies, that France should be downgraded, but this is not directly relevant. What is relevant is that if the market expects France to be downgraded, then market participants will naturally expect the EFSF to be stripped of its AAA rating. This, in turn, would undermine the business model of the EU support schemes (lend to distressed governments by accessing the market at low cost through a vehicle that is perceived to be risk-free).
Therefore, the downgrade of the US government, albeit by only one agency, risks accelerating history further in Europe. It does so by adding pressure on governments to move beyond their current crisis management approach in favour of the “end game” of fiscal integration and common bond issuance.
Jim Caron Interest Rates
We are watching developments in the funding markets. The impact on valuations of USTs as collateral for funding and financing will be a focal point of the S&P downgrade, because it represents the basis of the cost of money and leverage for the entire system. If these costs rise, then the downgrade could have a broader impact to other asset classes. In other words, if collateral and funding costs rise for USTs, it would be the functional equivalent of a margin call on the financial system. Our base case is that these costs will be unchanged (DTCC/FICC reaffirms no change to haircuts on UST collateral), and that providers of capital will not require increased margin for providing funding, but we will not know that until tomorrow and the days coming. This unknown presents a risk for the market on Monday. The main point is that liquidity and volatility of USTs will primarily dictate funding and financing costs for USTs, not just a downgrade from one ratings agency.
The market reaction in the next few days and weeks is uncertain, but we expect the following is likely to happen to different aspects of the interest rate and funding markets:
Short-term rates: The current haircut on UST collateral is 0-2%, and we do not expect that haircut to increase. The GC repo for overnight lending fell sharply late last week when the debt ceiling was raised and after the Bank of New York announced that it will charge a 13bp fee for large cash holdings. What happens to haircuts will be a key determinant because this is the functional equivalent of a margin call and could add to the stresses in the system. But we think that initially there will be good demand for higher quality collateral at the expense of more risky collateral. Consequently, this will increase the bid for T-Bills, short-term Treasuries, and other higher quality collateral.
Impact on the curve: Given the likely demand for front-end Treasuries, the initial reaction could be a steepening of the curve between 2s and 10s. But if there is a sustained sell off in risky assets, then we think there will be a safe haven bid to Treasuries, especially in the belly – 5s and 10s should outperform the rest of the curve. As for the long-end, the experience over the past few weeks has been for the 10s30s curve to steepen over fears of a downgrade. We would expect more of the same. Comparisons to Japan are being made, but
we think the situation is quite different. When Japan was downgraded in November 1998 yields rose and the curve steepened, led by the long end. We do not expect a sustained sell-off of that nature in the US.
Spread products: Agency debt and mortgages will implicitly have the same ratings as the US sovereign. We expect spreads to widen, but do not expect forced sales from banks, money managers, GSEs or the Treasury. Banks are unlikely to sell agency debt or mortgages since the Fed has confirmed that the risk weighting of their holdings in the securities portfolios will not change. For domestic banks, we think it will be a question of valuations, so over the near term they might wait to see what happens before they react. It could be a different story for foreign banks and it is hard to know what they will do. We don’t expect forced sales of mortgages by money managers either, as their investment mandates are benchmarked to specific indices, which will probably not be affected by a ratings downgrade.
In short, we do not expect forced sales of Treasury or spread products from domestic participants, although we do expect spread products to underperform Treasuries.
Hans Redeker Foreign Exchange
The fall of the carry trade. No doubt, the US sovereign debt downgrade on its own is a USD negative event. But with USD funded asset prices often falling at the same time, the USD may not even be the weakest currency when the markets open tomorrow. The reason is that the weakening global business outlook and EMU crisis complicate currency analysis.
We expect asset volatility to jump, forcing portfolio managers mechanically out of their positions. Often, positions are marked to market and when loss tolerances are exceeded, these positions need to be closed. When losses become substantial, portfolio managers will “take profits” in other areas. At this point, asset correlations jump higher – a typical by-product of a crisis – while hedging costs soar and liquidity dies. Past cycles did see the USD rally when stress developed.
The asset boom over the past couple of years has been mainly USD funded. The EUR has been used less for funding purposes, while the other low yielding currencies (JPY and CHF) were rarely used. However, there are substantial funding positions, which were implemented before the Lehman crisis. These positions are now sharply under water.
The SNB and BOJ face difficult jobs. The US downgrade will make it more difficult for Swiss and Japanese authorities to prevent the CHF and JPY from rallying further. Both currencies did rally on Friday, although the SNB allocated CHF50bln additional funds into its money markets, while Japan conducted its most aggressive one-day intervention since 2004 on Thursday. Unless, the SNB and the BOJ take further aggressive action first thing Monday morning, we expect to see the CHF and the JPY breaking higher once again. In order to weaken its currency, the BOJ is in a better position compared to the SNB, which runs excessive levels of currency reserves and has overstretched its balance sheet; CHFJPY should continue to rally.
The AUD will suffer. Falling asset and commodity prices puts commodity currencies into a defensive position. The US debt downgrade will increase uncertainties and investors are likely to continue to get more negative on the growth outlook. Consequently, commodity currencies are a “no go area” and are likely to be outperformed by GBP or even EUR.
Among the commodity bloc, AUD looks the most vulnerable. While Australia has little public sector debt, private sector leverage, especially in the corporate sector, is high. Australia’s net foreign liability position is only slightly below 60% of GDP and tightening global funding conditions should put the AUD under selling pressure. For that reason, we like AUDNOK short positions.
GBP will be liked for now. In the short-term, the GBP should serve as a safe haven. Further bad news coming out of the Middle East creates GBP demand. Moreover, Gilts are currently viewed as the best G-10 bond market (yield versus credit risk) by investors.
EUR in muddy waters. On the EUR side, things are complicated. The ECB may buy Italian bonds and try to sterilize these purchases. If it does, the resulting decline in EMU credit spreads should push the EUR higher (there will be an ECB announcement later). However, Bundesbank member Weidmann opposes this action by the ECB. And Germany has signaled that it does not want to increase the size of the EFSF, instead pushing for more fiscal consolidation efforts by the peripheral countries, which would be deflationary. All this suggests a highly volatile EUR. We expect the EUR to initially trade higher on Monday morning, but we are not convinced that it will stay bid over the course of the day.
China in focus. Much depends on what sovereign accounts choose to do, China in particular. Korea and Japan have already signaled that the loss of the AAA rating will not affect
would be another category of securities to be downgraded, since the AAAs in those structures are directly derived from the federal govt. guarantees. Also, when S&P placed the US first on negative watch, it also placed 46 CMBS transactions ($7.5bn) with some linkage to the US ratings on negative watch. It seems logical to expect these bonds to be downgraded. Much of the rest of the securitized product universe should see little or no downgrades from this.
The second issue of interest is what investors will do. In this context, the directive from the Fed that bank capital requirements will not change as a consequence of this downgrade is clearly positive and we expect this to apply broadly to the instruments discussed earlier. While regulators in other countries have not yet made similar pronouncements, to the extent they, in particular Asian central banks, stick with their UST holdings, it would seem unlikely that there would be incremental capital requirements imposed thus forcing banks to sell these downgraded securitized products. How non-bank investors might react is yet unclear but we don't expect substantial selling of these bonds as a result of these downgrades. In CMBS specifically, we think that recent actions by S&P in the CMBS space outside of their US sovereign downgrade, have significantly affected their credibility and it is unlikely that much, if any, forced selling of the downgraded CMBS would ensure as a consequence of the downgrades.
Third, we think that in the medium term, mortgages will do just fine as long as US Treasuries are seen as a relative safe haven regardless of this downgrade, even though it is possible that agency mortgage spreads widen on the open on Monday purely on originator selling while buyers sit on the sidelines. We view GSE credit and UST credit as one and the same and investors are not likely to make a distinction between the two either. Agency mortgages remain a deep and liquid market and investors, particularly real money and bank investors, can not afford to miss the spread pick up of mortgages. This is especially the case if rates remain low as we expect that they would.
If higher mortgage rates ensue as a consequence of the S&P downgrades, that would further dampen the already weak prepay environment. On a related note, we don't see the S&P downgrade as being particularly incrementally negative for US housing which remains weak anyway. As we have been highlighting for some time, the headwinds against housing in the US are: availability of credit and shadow inventory and not the level mortgage rates. Over the longer term, higher mortgage rates are obviously bad for housing demand as is any weakness in consumer confidence.
Finally, as the universe of AAA bonds shrinks, there should be a pick up in demand for "true" AAAs whose AAA rating is not dependent on UST ratings and remain AAA by all agencies. In the securitized product space, auto ABS is one sector where the AAA tranches saw little or no downgrades during the crisis. They are not affected now and they were not before and should see a pick up in demand for them. Falling in a similar category are a section of CLO AAAs that were either never downgraded or have been upgraded back to AAA by both S&P and Moody's. By our calculations, of the 585 US CLOs AAA tranches from 2005-2008 vintage that we have data for, 149 CLOs are currently rated AAA by both Moody’s and S&P. Given their attractive spread pick up L+180/200 bps, these tranches should be doubly attractive now. This pick up in investor interest should also be true of those legacy jumbo non-agency RMBS, including some recent re-remics that remain highly rated.
Adam Parker US Equities
We believe the market multiple will contract further due to lingering issues related to European sovereign debt, the US debt ceiling, and fears of a China hard landing. Our view is predicated on a belief that growth will ultimately slow and policy will not be a panacea. A catalyst for further multiple contraction will be, in our view, that the profit margin expectations embedded in the consensus outlook are too optimistic.
The recent price action dictates that a higher probability of a recession is now discounted than two weeks ago, but we don't think a recession is yet embedded in the US equity market, as downside would more typically be in excess of 30 percent. While a recession is possible – perhaps probable in the next two years – corporate balance sheets remain strong and select opportunities may emerge shortly should markets continue their recent decline. We recommend sectors and stocks with above average estimate achievability, including health care, utilities, and energy. We would avoid some of the economic-sensitive stocks with accelerating estimates, and as such are underweight the industrial and consumer discretionary sectors.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Conference Call Summary: Eurozone Debt Crisis and US Ratings Downgrade
Standard & Poor's downgrade of the US debt rating and increased tension in the Eurozone debt crisis have significantly increased downside risks and the probability of a bigger market correction in the near term. The downgrade, while not unexpected and subject to extra scrutiny because of an initial calculation error, amplifies already rising sovereign risk concerns in Europe. In fact, as our strategists argue below, the impact of the downgrade may be more acute in Europe than in the US by bringing the "end game" forward. Those risks are a further headwind to a slowing global economy, one that's likely to be buffeted by more fiscal tightening in 2012 brought on by the debt crises. With investors in de-risking mode and confidence fragile, failure to provide a more globally coordinated policy response could prove to be a tipping point for the markets, even though a recession is not our base case for next year.
Expect more volatility, while risk free assets are likely to benefit as risky assets come under additional stress. A paradoxical consequence of the rating downgrade is that Treasuries and the USD are likely to rally, at least in the near term, as investors assess the consequences of these latest developments. The same should be true for safe haven currencies (JPY and CHF), as well as some "true" AAA assets in the securitized product space that are not linked to Treasuries. Even if a more significant policy response is forthcoming, such as the European Central Bank (ECB) purchasing Italy sovereign bonds through the Securities Market Programme (SMP) to buy time to ratchet up the European Financial Stability Facility (EFSF) mechanism, investor skepticism about the efficacy of such efforts is likely to limit the near-term upside for risky assets from current levels.
Eurozone Debt Crisis and US Ratings Downgrade
Elga Bartsch Europe Economics
The euro area sovereign debt crisis is likely to escalate further. The downgrade of US government debt will likely add to the existing, severe pressure on the euro area periphery. The additional pressure – which my colleague Arnaud Mares will outline in more detail below – comes at an inopportune moment when the euro area is already experiencing an escalation of its sovereign debt crisis – an escalation that is due to half-hearted policy measures and to rising concerns about a slowdown in economic growth.
Markets remain on edge after the July 21 summit. The agreement reached by euro area governments at the July 21 summit to introduce precautionary credit lines, bond purchases in secondary markets and bank recapitalizations to the existing rescue mechanism clearly failed to calm markets. The implementation time lag, which means that the new features will only be up and running in September, unsettled investors who fret about the parliamentary approval process.
Likewise, Thursday’s ECB decision to reopen the Securities Market Program and start buying Portuguese and Irish government bonds again seem to have backfired. Not only was the policy action taken by the ECB viewed as "too little, too late" by many market participants, but the decision also revealed a deep rift in the ECB Governing Council. Reportedly, the two German Council Members and two Benelux representatives were against reopening the SMP. The market perception that the SMP does not have the full, undivided support of the Governing Council could undermine the program’s effectiveness, also should the ECB decide to broaden the purchase program to bigger euro-area bond markets, such as Italian BTPs for instance.
More fundamentally, the controversy in the Governing Council raises an important question about the effectiveness of the ECB’s intervention in government bond markets. Under the enhanced rescue mechanism (see Euroland Economics: A Step Forward, But Not a Big Leap, July 22, 2011), bond purchases by the rescue fund would need to be sanctioned by a unanimous decision of all euro area finance ministers. The ECB decision to buy bonds, by contrast, does not require unanimity, as we have already seen last year. True, given its full operational independence enshrined in the European Treaty, the ECB can push ahead with its bond purchases. But, it would do so at the risk of undermining public support for the euro in the core countries. Hence, fending off a bond market meltdown in the non-core countries in the short-term could come at the cost of a rising risk of EMU breakup in the long term.
The escalating sovereign debt crisis and its spillover effects into bank funding markets add to the serious headwinds the euro area economy is already facing. Back in early April, we cut our 2012 GDP forecast to a below consensus 1.2% based on our projection that euro area growth would slow markedly in the second half of this year. Recent developments suggest to us that we might still be too optimistic on the growth outlook. Instead of the euro area economy growing at stall-speed over the winter quarters, stagnation, if not an outright contraction, might actually be more likely. Against such a backdrop, the next ECB interest rate decision could also be a cut rather than the hike our current forecast shows. That said, the ECB’s August press conference still sent a strong signal that, at least for now, the Bank remains in tightening mode.
Arnaud Mares Sovereign Economics
We focus on the two key take-aways from the downgrade. Prior to the ratings downgrade by S&P, we had thought the rating agencies would err on the side of caution and that a downgrade was less likely than the market expected. In light of the downgrade, there are two main take-aways, one for the US, one for Europe.
For the US, what is the meaning of a downgrade from AAA to AA? It does create higher risks for creditors, but not necessarily in the form of default.
A downgrade from AAA to AA does not imply a meaningfully higher risk of default, as we have outlined in the past few weeks. Based on Moody's calibration of the expected default at these levels, the probability of default over a 10-year horizon is 0.0% at Aaa and 0.1% at Aa1 (equivalent of AA+). This is a theoretical calculation because there is no historical data of sovereign default at these rating levels.
What this means is that the rating agencies cannot measure with any degree of accuracy the difference in credit risk between a AAA and a AA sovereign. What they are measuring and reflecting in their ratings at this end of the scale is the intensity of the conflict between creditors of
Eurozone Debt Crisis and US Ratings Downgrade
Elga Bartsch Europe Economics
The euro area sovereign debt crisis is likely to escalate further. The downgrade of US government debt will likely add to the existing, severe pressure on the euro area periphery. The additional pressure – which my colleague Arnaud Mares will outline in more detail below – comes at an inopportune moment when the euro area is already experiencing an escalation of its sovereign debt crisis – an escalation that is due to half-hearted policy measures and to rising concerns about a slowdown in economic growth.
Markets remain on edge after the July 21 summit. The agreement reached by euro area governments at the July 21 summit to introduce precautionary credit lines, bond purchases in secondary markets and bank recapitalizations to the existing rescue mechanism clearly failed to calm markets. The implementation time lag, which means that the new features will only be up and running in September, unsettled investors who fret about the parliamentary approval process.
Likewise, Thursday’s ECB decision to reopen the Securities Market Program and start buying Portuguese and Irish government bonds again seem to have backfired. Not only was the policy action taken by the ECB viewed as "too little, too late" by many market participants, but the decision also revealed a deep rift in the ECB Governing Council. Reportedly, the two German Council Members and two Benelux representatives were against reopening the SMP. The market perception that the SMP does not have the full, undivided support of the Governing Council could undermine the program’s effectiveness, also should the ECB decide to broaden the purchase program to bigger euro-area bond markets, such as Italian BTPs for instance.
More fundamentally, the controversy in the Governing Council raises an important question about the effectiveness of the ECB’s intervention in government bond markets. Under the enhanced rescue mechanism (see Euroland Economics: A Step Forward, But Not a Big Leap, July 22, 2011), bond purchases by the rescue fund would need to be sanctioned by a unanimous decision of all euro area finance ministers. The ECB decision to buy bonds, by contrast, does not require unanimity, as we have already seen last year. True, given its full operational independence enshrined in the European Treaty, the ECB can push ahead with its bond purchases. But, it would do so at the risk of undermining public support for the euro in the core countries. Hence, fending off a bond market meltdown in the non-core countries in the short-term could come at the cost of a rising risk of EMU breakup in the long term.
The escalating sovereign debt crisis and its spillover effects into bank funding markets add to the serious headwinds the euro area economy is already facing. Back in early April, we cut our 2012 GDP forecast to a below consensus 1.2% based on our projection that euro area growth would slow markedly in the second half of this year. Recent developments suggest to us that we might still be too optimistic on the growth outlook. Instead of the euro area economy growing at stall-speed over the winter quarters, stagnation, if not an outright contraction, might actually be more likely. Against such a backdrop, the next ECB interest rate decision could also be a cut rather than the hike our current forecast shows. That said, the ECB’s August press conference still sent a strong signal that, at least for now, the Bank remains in tightening mode.
Arnaud Mares Sovereign Economics
We focus on the two key take-aways from the downgrade. Prior to the ratings downgrade by S&P, we had thought the rating agencies would err on the side of caution and that a downgrade was less likely than the market expected. In light of the downgrade, there are two main take-aways, one for the US, one for Europe.
For the US, what is the meaning of a downgrade from AAA to AA? It does create higher risks for creditors, but not necessarily in the form of default.
A downgrade from AAA to AA does not imply a meaningfully higher risk of default, as we have outlined in the past few weeks. Based on Moody's calibration of the expected default at these levels, the probability of default over a 10-year horizon is 0.0% at Aaa and 0.1% at Aa1 (equivalent of AA+). This is a theoretical calculation because there is no historical data of sovereign default at these rating levels.
What this means is that the rating agencies cannot measure with any degree of accuracy the difference in credit risk between a AAA and a AA sovereign. What they are measuring and reflecting in their ratings at this end of the scale is the intensity of the conflict between creditors of
governments against other stakeholders that also have a claim on the government’s resources (i.e., the taxpayers and the recipients of public spending, ranging from government employees to contractors and suppliers and beneficiaries of entitlements and other social expenditure, etc.).
Even if this conflict were to be resolved against the interests of the creditors, this does not necessarily mean default, and resolution is indeed extraordinarily unlikely to take this form in a large country with fiat money. There are other ways to inflict losses on creditors that are considerably more likely because they’re less damaging to society and the economy and, unlike default, have been used repeatedly and successfully in the past, including financial repression and monetisation of the debt and eventually inflation.
From a fundamental perspective, the main lasting effect of Standard & Poor's downgrade ought to be to a greater market focus on these outcomes.
The second take-away, paradoxically, is that the downgrade of the US government may have more relevance for Europe than for the US. The reason is that a downgrade of the US government to the AA range raises legitimate questions as to whether European governments will remain rated AAA. In particular, those with vulnerable public finances (UK) and especially governments with a limited track record on debt consolidation and no absolute control over their central bank (France).
The focus on France will necessarily intensify also as a consequence of the likelihood that Italy and Spain are downgraded by rating agencies in the next six weeks or so. Downgrading Italy and Spain would “free up” space in the upper reaches of the AA range and, given that rating agencies rate on a comparative basis, would feed market expectations that they will fill this opened up space by downgrading France. I remain skeptical, based on the methodologies published by the rating agencies, that France should be downgraded, but this is not directly relevant. What is relevant is that if the market expects France to be downgraded, then market participants will naturally expect the EFSF to be stripped of its AAA rating. This, in turn, would undermine the business model of the EU support schemes (lend to distressed governments by accessing the market at low cost through a vehicle that is perceived to be risk-free).
Therefore, the downgrade of the US government, albeit by only one agency, risks accelerating history further in Europe. It does so by adding pressure on governments to move beyond their current crisis management approach in favour of the “end game” of fiscal integration and common bond issuance.
Jim Caron Interest Rates
We are watching developments in the funding markets. The impact on valuations of USTs as collateral for funding and financing will be a focal point of the S&P downgrade, because it represents the basis of the cost of money and leverage for the entire system. If these costs rise, then the downgrade could have a broader impact to other asset classes. In other words, if collateral and funding costs rise for USTs, it would be the functional equivalent of a margin call on the financial system. Our base case is that these costs will be unchanged (DTCC/FICC reaffirms no change to haircuts on UST collateral), and that providers of capital will not require increased margin for providing funding, but we will not know that until tomorrow and the days coming. This unknown presents a risk for the market on Monday. The main point is that liquidity and volatility of USTs will primarily dictate funding and financing costs for USTs, not just a downgrade from one ratings agency.
The market reaction in the next few days and weeks is uncertain, but we expect the following is likely to happen to different aspects of the interest rate and funding markets:
Short-term rates: The current haircut on UST collateral is 0-2%, and we do not expect that haircut to increase. The GC repo for overnight lending fell sharply late last week when the debt ceiling was raised and after the Bank of New York announced that it will charge a 13bp fee for large cash holdings. What happens to haircuts will be a key determinant because this is the functional equivalent of a margin call and could add to the stresses in the system. But we think that initially there will be good demand for higher quality collateral at the expense of more risky collateral. Consequently, this will increase the bid for T-Bills, short-term Treasuries, and other higher quality collateral.
Impact on the curve: Given the likely demand for front-end Treasuries, the initial reaction could be a steepening of the curve between 2s and 10s. But if there is a sustained sell off in risky assets, then we think there will be a safe haven bid to Treasuries, especially in the belly – 5s and 10s should outperform the rest of the curve. As for the long-end, the experience over the past few weeks has been for the 10s30s curve to steepen over fears of a downgrade. We would expect more of the same. Comparisons to Japan are being made, but
we think the situation is quite different. When Japan was downgraded in November 1998 yields rose and the curve steepened, led by the long end. We do not expect a sustained sell-off of that nature in the US.
Spread products: Agency debt and mortgages will implicitly have the same ratings as the US sovereign. We expect spreads to widen, but do not expect forced sales from banks, money managers, GSEs or the Treasury. Banks are unlikely to sell agency debt or mortgages since the Fed has confirmed that the risk weighting of their holdings in the securities portfolios will not change. For domestic banks, we think it will be a question of valuations, so over the near term they might wait to see what happens before they react. It could be a different story for foreign banks and it is hard to know what they will do. We don’t expect forced sales of mortgages by money managers either, as their investment mandates are benchmarked to specific indices, which will probably not be affected by a ratings downgrade.
In short, we do not expect forced sales of Treasury or spread products from domestic participants, although we do expect spread products to underperform Treasuries.
Hans Redeker Foreign Exchange
The fall of the carry trade. No doubt, the US sovereign debt downgrade on its own is a USD negative event. But with USD funded asset prices often falling at the same time, the USD may not even be the weakest currency when the markets open tomorrow. The reason is that the weakening global business outlook and EMU crisis complicate currency analysis.
We expect asset volatility to jump, forcing portfolio managers mechanically out of their positions. Often, positions are marked to market and when loss tolerances are exceeded, these positions need to be closed. When losses become substantial, portfolio managers will “take profits” in other areas. At this point, asset correlations jump higher – a typical by-product of a crisis – while hedging costs soar and liquidity dies. Past cycles did see the USD rally when stress developed.
The asset boom over the past couple of years has been mainly USD funded. The EUR has been used less for funding purposes, while the other low yielding currencies (JPY and CHF) were rarely used. However, there are substantial funding positions, which were implemented before the Lehman crisis. These positions are now sharply under water.
The SNB and BOJ face difficult jobs. The US downgrade will make it more difficult for Swiss and Japanese authorities to prevent the CHF and JPY from rallying further. Both currencies did rally on Friday, although the SNB allocated CHF50bln additional funds into its money markets, while Japan conducted its most aggressive one-day intervention since 2004 on Thursday. Unless, the SNB and the BOJ take further aggressive action first thing Monday morning, we expect to see the CHF and the JPY breaking higher once again. In order to weaken its currency, the BOJ is in a better position compared to the SNB, which runs excessive levels of currency reserves and has overstretched its balance sheet; CHFJPY should continue to rally.
The AUD will suffer. Falling asset and commodity prices puts commodity currencies into a defensive position. The US debt downgrade will increase uncertainties and investors are likely to continue to get more negative on the growth outlook. Consequently, commodity currencies are a “no go area” and are likely to be outperformed by GBP or even EUR.
Among the commodity bloc, AUD looks the most vulnerable. While Australia has little public sector debt, private sector leverage, especially in the corporate sector, is high. Australia’s net foreign liability position is only slightly below 60% of GDP and tightening global funding conditions should put the AUD under selling pressure. For that reason, we like AUDNOK short positions.
GBP will be liked for now. In the short-term, the GBP should serve as a safe haven. Further bad news coming out of the Middle East creates GBP demand. Moreover, Gilts are currently viewed as the best G-10 bond market (yield versus credit risk) by investors.
EUR in muddy waters. On the EUR side, things are complicated. The ECB may buy Italian bonds and try to sterilize these purchases. If it does, the resulting decline in EMU credit spreads should push the EUR higher (there will be an ECB announcement later). However, Bundesbank member Weidmann opposes this action by the ECB. And Germany has signaled that it does not want to increase the size of the EFSF, instead pushing for more fiscal consolidation efforts by the peripheral countries, which would be deflationary. All this suggests a highly volatile EUR. We expect the EUR to initially trade higher on Monday morning, but we are not convinced that it will stay bid over the course of the day.
China in focus. Much depends on what sovereign accounts choose to do, China in particular. Korea and Japan have already signaled that the loss of the AAA rating will not affect
would be another category of securities to be downgraded, since the AAAs in those structures are directly derived from the federal govt. guarantees. Also, when S&P placed the US first on negative watch, it also placed 46 CMBS transactions ($7.5bn) with some linkage to the US ratings on negative watch. It seems logical to expect these bonds to be downgraded. Much of the rest of the securitized product universe should see little or no downgrades from this.
The second issue of interest is what investors will do. In this context, the directive from the Fed that bank capital requirements will not change as a consequence of this downgrade is clearly positive and we expect this to apply broadly to the instruments discussed earlier. While regulators in other countries have not yet made similar pronouncements, to the extent they, in particular Asian central banks, stick with their UST holdings, it would seem unlikely that there would be incremental capital requirements imposed thus forcing banks to sell these downgraded securitized products. How non-bank investors might react is yet unclear but we don't expect substantial selling of these bonds as a result of these downgrades. In CMBS specifically, we think that recent actions by S&P in the CMBS space outside of their US sovereign downgrade, have significantly affected their credibility and it is unlikely that much, if any, forced selling of the downgraded CMBS would ensure as a consequence of the downgrades.
Third, we think that in the medium term, mortgages will do just fine as long as US Treasuries are seen as a relative safe haven regardless of this downgrade, even though it is possible that agency mortgage spreads widen on the open on Monday purely on originator selling while buyers sit on the sidelines. We view GSE credit and UST credit as one and the same and investors are not likely to make a distinction between the two either. Agency mortgages remain a deep and liquid market and investors, particularly real money and bank investors, can not afford to miss the spread pick up of mortgages. This is especially the case if rates remain low as we expect that they would.
If higher mortgage rates ensue as a consequence of the S&P downgrades, that would further dampen the already weak prepay environment. On a related note, we don't see the S&P downgrade as being particularly incrementally negative for US housing which remains weak anyway. As we have been highlighting for some time, the headwinds against housing in the US are: availability of credit and shadow inventory and not the level mortgage rates. Over the longer term, higher mortgage rates are obviously bad for housing demand as is any weakness in consumer confidence.
Finally, as the universe of AAA bonds shrinks, there should be a pick up in demand for "true" AAAs whose AAA rating is not dependent on UST ratings and remain AAA by all agencies. In the securitized product space, auto ABS is one sector where the AAA tranches saw little or no downgrades during the crisis. They are not affected now and they were not before and should see a pick up in demand for them. Falling in a similar category are a section of CLO AAAs that were either never downgraded or have been upgraded back to AAA by both S&P and Moody's. By our calculations, of the 585 US CLOs AAA tranches from 2005-2008 vintage that we have data for, 149 CLOs are currently rated AAA by both Moody’s and S&P. Given their attractive spread pick up L+180/200 bps, these tranches should be doubly attractive now. This pick up in investor interest should also be true of those legacy jumbo non-agency RMBS, including some recent re-remics that remain highly rated.
Adam Parker US Equities
We believe the market multiple will contract further due to lingering issues related to European sovereign debt, the US debt ceiling, and fears of a China hard landing. Our view is predicated on a belief that growth will ultimately slow and policy will not be a panacea. A catalyst for further multiple contraction will be, in our view, that the profit margin expectations embedded in the consensus outlook are too optimistic.
The recent price action dictates that a higher probability of a recession is now discounted than two weeks ago, but we don't think a recession is yet embedded in the US equity market, as downside would more typically be in excess of 30 percent. While a recession is possible – perhaps probable in the next two years – corporate balance sheets remain strong and select opportunities may emerge shortly should markets continue their recent decline. We recommend sectors and stocks with above average estimate achievability, including health care, utilities, and energy. We would avoid some of the economic-sensitive stocks with accelerating estimates, and as such are underweight the industrial and consumer discretionary sectors.
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