August 8, 2011

U.S. Downgrade is a Sideshow
Bottom Line

The U.S. Treasury says that the decision by Standard & Poor’s rating agency to downgrade U.S. debt is based on flawed analysis. While I agree with S&P that political brinksmanship and extremism has reduced the prospects for meaningful deficit reduction in the U.S., S&P admits that there is no issue regarding the U.S.’s ability or willingness to pay for its debt. It is hard for me to believe that the U.S. debt rating should be at the level of Lichtenstein and New Zealand, rather than the U.K., Germany or France. Indeed, S&P was forced to postpone their announcement Friday morning when the Treasury, having received an early pre-release of their announcement, found a mistake in their calculations.

The U.S. Treasury department points out on their website that S&P made an arithmetic error in calculating future U.S. debt ratios, the impact of which was to overstate projected deficits by $2 trillion over 10 years. S&P acknowledged this error in private conversations with Treasury early Friday afternoon (delaying their announcement) and then publicly early Saturday morning. Nevertheless, they chose to issue a downgrade after 8 PM on Friday on the grounds of political turmoil rather than the inability of the U.S. to meet its credit obligations. It downgraded long-term U.S. debt to AA+ and—adding insult to injury—put the new grade on “negative outlook,” meaning that the U.S. has little chance of an upgrade anytime soon.

S&P said the downgrade “reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.” It also blamed the weakened “effectiveness, stability, and predictability” of U.S. policy making and political institutions at a time when challenges are mounting.

The Treasury has responded aggressively to this action, calling S&P’s move a “$2 trillion mistake” and said there is no justifiable rationale for the decision. John Bellows, acting assistant secretary for economic policy said that, “the magnitude of this mistake—and the haste with which S&P changed its principal rationale for action when presented with this error—raise fundamental questions about the credibility and integrity of S&P’s ratings action.”

Most likely, the impact of this downgrade will be more psychological than actual, as Moody’s and Fitch have recently reaffirmed the U.S.’s triple-A rating. S&P may be covering itself after doing so poorly during the housing meltdown. If they are right, they can’t be blamed for not having seen the risk this time. And if they are wrong, they can say their warning caused the Congress to do the right things to avert a catastrophe. It’s Chicken Little claiming that his warnings stopped the sky from falling. Because of its damaged reputation, the risks S&P faces are not symmetric, and the lack of symmetry will bias the ratings it issues toward ensuring it doesn’t miss another problem. The upshot is that false positives, as I believe this is, will be much more likely.

Politically, this is bad for Obama and for some Congressmen. Tax reform must be considered. Otherwise, the debt reduction math just doesn’t work. I agree with S&P that waiting until after the election to really deal with the issue puts the U.S. in an even deeper hole. The Supercommittee should agree to tax reform in addition to spending cuts and Medicare and Social Security reform must be on the table.

My greatest concern is that market sentiment is so bad and fear so rife that this warning could be seen as another ‘nail in the coffin’ and it could cause further selling in the stock and commodity markets Sunday night and Monday. Shares listed on equity markets in the Middle East, which were open on Sunday, tumbled on the back of the news of the downgrade. Israel’s TA-25 fell by the most in almost 11 years, closing down 7%. Dubai’s main index dropped by the most since February and Saudi Arabia’s main bourse closed down 5.5% on Saturday.

Another major concern is the response of foreign government holders of U.S. Treasury debt, especially China, which is the largest by far. Today, foreigners own a record high 46% of U.S. Treasuries. G-7 and G-20 leaders are slated to confer as Asian markets open later today to calm roiled markets. Japanese and European leaders have stated their support for continued Treasury holdings. China issued a biting statement: “The days when the debt-ridden Uncle Sam could leisurely squander unlimited overseas borrowing appeared to be numbered,” said a commentary published by the official Xinhua news agency. “To cure its addiction to debts, the United States has to re-establish the common sense principle that one should live within its means.” Despite this fiery rhetoric, Beijing’s insistence on keeping a lid on the value of its own currency means it will have to continue investing its swelling foreign reserves in U.S. government debt. Japan, too, is worried about a rise in its overvalued currency. It has intervened repeatedly to forestall a rise in the yen and announced Sunday that it would sell yen again following last week’s move if it sees speculative trades driving the currency higher.

When the dust clears, it is doubtful that Treasury yields will have risen much from what they would have been without the downgrade, and they have fallen sharply in any event, so the Treasury’s cost of funds will not be meaningfully affected by the downgrade. The Treasury market will still be seen as a safe haven. There is no other market with its depth and liquidity.

Cash hoarding, however, will continue to make it nearly impossible for the Fed to do anything that would help the economy near term. Hopefully, the incoming data for the U.S. will slowly improve, as we expect. The supply disruptions emanating from the Japanese tsunami are dissipating. Auto production is rising sharply this quarter and gasoline prices are falling. The sharp decline in oil and other commodity prices is bringing down global inflation and boosting incomes. Corporate earnings are very strong and they should be passing their profit growth into additional employment and investment. They had been showing signs of doing this until recent policy confusion over the debt ceiling appeared to damage business confidence. Friday’s slightly better jobs report in the U.S. offers at least some ray of hope.

Troubling as it might be, the U.S. debt downgrade is really a sideshow. The main event continues to be the European sovereign debt crisis. The abject failure of the eurozone to conduct a successful Greek rescue operation threatens contagion to Italy and Spain. The situation is still very unstable and Berlusconi’s promises on Friday to accelerate Italy’s fiscal cuts can only assuage concerns temporarily. Italy has the third largest bond market in the world behind Japan and the U.S. The ECB is expected to buy Italian and Spanish bonds on a massive scale on Monday’s open, but a German-led faction reportedly opposes this action, which is seen to be a watershed, signalling that the ECB is willing to be the lender of last resort for the eurozone. The squabbling in Europe is at least as damaging to the global economy and financial stability as anything going on in Washington. Germany says all options are on the table, except the one that might work, which is a greater issuance of eurobonds. President Nicolas Sarkozy of France had a chance to explain this to Chancellor Angela Merkel on the phone on Friday. Either Europe has to agree to become a ‘transfer region’ with a single monetary and fiscal authority and one eurobond market (with much less individual national sovereign power) or allow for a break up of the EU.

Bottom Line for Canada: In this environment, commodity prices likely remain soft and the Canadian dollar is vulnerable and extremely volatile. That, in itself, is not bad for the Canadian economy, but our stock market has taken a beating and it’s probably not over. This negative wealth effect is not good for confidence and spending. I think our housing market, especially in Vancouver and Toronto, might be vulnerable. The Canadian current account deficit is very high and this puts the Bank of Canada on hold for some time. Messieurs Harper, Flaherty and Carney can only counsel Canadians to remain calm, reassert that the domestic fundamentals are good and pressure G-20 leaders to take the necessary actions to avert a crisis.