Best of the Week
Most Popular
1. Market Decline Will Lead To Pension Collapse, USD Devaluation, And NWO - Raymond_Matison
2.Uber’s Nightmare Has Just Started - Stephen_McBride
3.Stock Market Crash Black Swan Event Set Up Sept 12th? - Brad_Gudgeon
4.GDow Stock Market Trend Forecast Update - Nadeem_Walayat
5.Gold Significant Correction Has Started - Clive_Maund
6.British Pound GBP vs Brexit Chaos Timeline - Nadeem_Walayat
7.Cameco Crash, Uranium Sector Won’t Catch a break - Richard_Mills
8.Recession 2020 Forecast : The New Risks & New Profits Of A Grand Experiment - Dan_Amerman
9.Gold When Global Insanity Prevails - Michael Ballanger
10.UK General Election Forecast 2019 - Betting Market Odds - Nadeem_Walayat
Last 7 days
YouGov's MRP Poll Final Tory Seats Forecast Revised Down From 359 to 338, Possibly Lower? - 10th Dec 19
What UK Economy (Average Earnings) Predicts for General Election Results 2019 - 10th Dec 19
Labour vs Tory Manifesto's UK General Election Parliamentary Seats Forecast 2019 - 10th Dec 19
Lumber is about to rally and how to play it with this ETF - 10th Dec 19
Social Mood and Leaders Impact on General Election Forecast 2019 - 9th Dec 19
Long-term Potential for Gold Remains Strong! - 9th Dec 19
Stock and Financial Markets Review - 9th Dec 19
Labour / Tory Manifesto's Impact on UK General Election Seats Forecast 2019 - 9th Dec 19
Tory Seats Forecast 2019 General Election Based on UK House Prices Momentum Analysis - 9th Dec 19
Top Tory Marginal Seats at Risk of Loss to Labour and Lib Dems - Election 2019 - 9th Dec 19
UK House Prices Momentum Tory Seats Forecast General Election 2019 - 8th Dec 19
Why Labour is Set to Lose Sheffield Seats at General Election 2019 - 8th Dec 19
Gold and Silver Opportunity Here Is As Good As It Gets - 8th Dec 19
High Yield Bond and Transports Signal Gold Buy Signal - 8th Dec 19
Gold & Silver Stocks Belie CoT Caution - 8th Dec 19
Will Labour Government Spending Bankrupt Britain? UK Debt and Deficits - 7th Dec 19
Lib Dem Fake Tory Election Leaflets - Sheffield Hallam General Election 2019 - 7th Dec 19
You Should Be Buying Gold Stocks Now - 6th Dec 19
The End of Apple Has Begun - 6th Dec 19
How Much Crude Oil Do You Unknowingly Eat? - 6th Dec 19
Labour vs Tory Manifesto Voter Bribes Impact on UK General Election Forecast - 6th Dec 19
Gold Price Forecast – Has the Recovery Finished? - 6th Dec 19
Precious Metals Ratio Charts - 6th Dec 19
Climate Emergency vs Labour Tree Felling Councils Reality - Sheffield General Election 2019 - 6th Dec 19
What Fake UK Unemployment Statistics Predict for General Election Result 2019 - 6th Dec 19
What UK CPI, RPI and REAL INFLATION Predict for General Election Result 2019 - 5th Dec 19
Supply Crunch Coming as Silver Miners Scale Back - 5th Dec 19
Gold Will Not Surpass Its 1980 Peak - 5th Dec 19
UK House Prices Most Accurate Predictor of UK General Elections - 2019 - 5th Dec 19
7 Year Cycles Can Be Powerful And Gold Just Started One - 5th Dec 19
Lib Dems Winning Election Leaflets War Against Labour - Sheffield Hallam 2019 - 5th Dec 19
Do you like to venture out? Test yourself and see what we propose for you - 5th Dec 19
Great Ways To Make Money Over Time - 5th Dec 19
Calculating Your Personal Cost If Stock, Bond and House Prices Return To Average - 4th Dec 19
Will Labour Government Plant More Tree's than Council's Like Sheffield Fell? - 4th Dec 19
What the UK Economy GDP Growth Rate Predicts for General Election 2019 - 4th Dec 19
Gold, Silver and Stock Market Big Picture: Seat Belts Tightened - 4th Dec 19
Online Presence: What You Need to Know About What Others Know About You - 4th Dec 19
New Company Tip: How To Turn Prospects into Customers with CRM Tech - 4th Dec 19
About To Relive The 2007 US Housing Market Real Estate Crash Again? - 3rd Dec 19
How Far Will Gold Reach Before the Upcoming Reversal? - 3rd Dec 19
Is The Current Stock Market Rally A True Valuation Rally or Euphoria? - 3rd Dec 19
Why Shale Oil Not Viable at $45WTI Anymore, OPEC Can Dictate Price Again - 3rd Dec 19
Lib Dem Election Dodgy Leaflets - Sheffield Hallam Battle General Election 2019 - 3rd Dec 19
Land Rover Discovery Sport Brake Pads Uneven Wear Dash Warning Message at 2mm Mark - 3rd Dec 19
The Rise and Evolution of Bitcoin - 3rd Dec 19
Virtual games and sport, which has one related to the other - 3rd Dec 19

Market Oracle FREE Newsletter

UK House prices predicting general election result

U.S. Credit Rating Downgrade, We Are Not AAA

Interest-Rates / Credit Crisis 2011 Aug 08, 2011 - 06:05 AM GMT

By: Vitaliy_Katsenelson


Best Financial Markets Analysis ArticleI have received many emails and a few calls from friends, asking one question: What are the consequences of the downgrade? So I decided to put my thoughts on paper. I break up the consequences into three categories: fundamental (the impact on the economy), emotional (the short-term impact on the market), and political (will it change anything in Washington DC?).

Fundamental: AA+ is the new AAA.

The Fed and the FDIC set bank reserve requirements; they decide what is quality and what is not on banks’ balance sheets. To little surprise, a few hours after the downgrade, the Fed and FDIC announced that AA+ US debt is as good as AAA, and thus banks’ reserve requirements will not change and bank lending should not change either. Though we’ll probably get a few downgrades of financial companies holding US treasuries, the direct impact on financial institutions should be negligible.

The indirect impact of the downgrade is worrisome, however, because unknowns are simply … unknown. The AAA government debt rating is a foundation stone of the world financial system, and when it shifts, even a little, other things may shift as well. Unintended consequences may be surprising. For instance, until Lehman collapsed it was hard to imagine that the Reserve Fund (the first US money market fund) would see its price decline a few pennies bellow the dollar, causing a massive exodus out of money market funds and a resultant freezing of the commercial paper market – the lifeblood of corporate America. The federal government had to step in and guarantee all money markets to stop the bleeding.

Scandinavian countries and Switzerland are probably the only true AAA nations left, but their economies are not big enough for them to field reserve currencies, and in fact Switzerland is trying to devalue its currency, as its exporters are hurting from the highly appreciated Swiss franc.

The US’s cost of borrowing is unlikely to increase, not yet, not while PIIGS (Portugal, Italy, Ireland, Greece, and Spain) are rampaging through Europe. The US still has the largest, most robust, most diversified economy, and despite our problems we are in better shape than Western Europe, which is chained to a common currency and whose banks are overleveraged through their exposure to PIIGS.

The only downgrade that will really matter to our cost of borrowing in the long run is the one imposed by the bond markets. Credit agency ratings are important in the short run, because their ratings are deeply embedded in the financial system by regulators (and governments), but in the longer run it is the markets’ own ratings that will matter. Markets will perform their own credit analysis of countries and will do their own debt downgrading, i.e., they’ll demand higher interest rates. Japanese debt was downgraded to AA- in January 2011. It was a nonevent. Despite being the most indebted developed nation, Japan is still borrowing at the same pre-downgrade rates, which are half of the rates the US government pays on its debt. On the other hand, Italy’s 10-year bond rates jumped to 6% in August without any downgrade by credit agencies: the markets did their own credit analysis.

The chance the US will default on its debt in a traditional sense is zero. Yes, zero. All of our obligations are in US dollars. Governments that can print their own currencies don’t go through traditional default, they default through the printing press (i.e., by inflation). It will take a few more dollars to buy bread, vodka, potatoes, and cigarettes (I am going authentic here) year after year. The US government will honor its obligations in nominal terms (ignoring inflation), meanwhile defaulting on its debt in real terms (adjusted for inflation).

Emotional Consequences

I was going to write a note on this topic before the S&P downgrade, so I’ll expand it a bit further. I was on a radio show on Friday, and I was asked why the markets declined 7% this week. I said, “Markets were ignoring bad news for a while and now decided to stop ignoring it.” I sounded smart; I even patted myself on the back.

But a few hours later I was driving home and started thinking what baloney that was. The market declined because it declined. There is no need for an explanation, because there really is not one. We don’t need an explanation why the market goes up, we consider it our birthright. But a market decline seems somewhat unnatural to us. Financial TV explains to us in great detail the market’s tick by tick movements. For example, on Friday the jobs report came out – the US economy added 117,000 jobs. The Dow went up 150 points or so right away, as financial TV explained that the market was expecting a worse number, so this was a good surprise. Then, two hours later, the market declined 250 points (that is, down 400 points from the opening high); and the explanation we heard was that the job number was not really that good, after all, because we needed 150,000 jobs or so just to maintain our current same employment level, because of population growth, so in reality employment had declined by 33,000 jobs.

I understand why financial TV does this. You are not going to stay tuned to financial TV all day long if all you hear is that the market went up 150 points because it did, and then declined 250 points because it does that from time to time. This would be some boring TV.

In reality, market movements – including intraday, daily, and monthly movements – are largely random and not predictable. Explaining what they do tick by tick on a continuous basis has as much value as trying to come up with a rational explanation why the ball landed on the 9 on the roulette table in Bellagio instead of 10.

This brings me to the question of how markets will react to the downgrade. I have no idea. If they were to decline, I would not mind, as we have a little bit less than 30% cash, and I want to put it to work (we bought a few stocks last week). Also, a bulk of the companies in our portfolio are actively buying back a meaningful amount of their stock in the open market, and I want them to buy their stock cheaper, as it will raise their earnings power. But if you are an investor you need to have a time horizon longer than a week or a month.

Political Consequences

Hallelujah! Last week I wrote about the Pyrrhic victory of the debt-ceiling debate:

A Pyrrhic victory is so-called after the Greek king Pyrrhus, who, after suffering heavy losses in defeating the Romans in 279 B.C., said to those sent to congratulate him, “Another such victory over the Romans and we are undone.”

A quick thought on the debt-ceiling debacle. I believe that by August 2nd we’ll see the debt ceiling increased, as the cost of not doing so is simply unknown and most likely too high. However, it will be a Pyrrhic victory for whatever side claims it, as the victory will undoubtedly undermine the world’s trust in the US dollar and its debt ($37.5 billion leaving money-market funds that invest in Treasuries in one week proves the latter point already).

And this is what S&P delicately wrote about our politicians:

Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a 'AAA' rating and with 'AAA' rated sovereign peers.

An AAA-rated nation doesn’t threaten a default to achieve its political agenda; this is what you’d expect a banana republic to do. I really hope the downgrade was the slap on the face our politicians so badly needed. Both parties represent a class, not Americans who share the same sky and constitution, but rich and poor. Each party wants to solve the debt problem at the expense of the other class. Unfortunately, we have a government we cannot afford, thus both “classes” need to share in the pain: the ones that have the money need to pay higher taxes, and the less-rich need to have less government.

When I told my wife at the dinner table on Friday that the US debt had been downgraded from AAA to AA+, my five-year-old daughter asked if AAA batteries were still good. I said they were. The age of innocence. My daughter still believes her father can fix any problem.

The S&P, as usual, is too late to downgrade. The US has not been a AAA-rated nation in the absolute sense for a while. Will this downgrade really change anything? In the long run, that is, beyond the uncertain short run, it will either have almost no effect or be a slightly positive event, as it should serve as a wake-up call we all badly need. It is too easy to put all the blame on politicians –if we are really honest with ourselves, we have to remember that we’re the ones who reelect them, term after term.

P.S. My father once told me a joke that may be pertinent: A Jewish gentleman created a lot a political havoc in Soviet Russia. The authorities thought long and hard about what to do with him, and decided the easiest way to shut him up was to ship him out of Russia. They said, “Here is a globe. Pick a country, any country; we’ll buy you a one-way ticket to the destination of your choice.” The gentleman looked the globe over very carefully and said, “Do you have another globe?”

P.S.S. I wrote this on Saturday and was pleasantly surprised that Sir Alan Greenspan and Mohamed El-Erian, PIMCO’s CEO, made similar points on Sunday.

P.S.S.S. Watercolor "Lilacs" by my father Naum Katsenelson

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

© 2011 Copyright Vitaliy Katsenelson - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules