Why this is worse than expected:
The turmoil following the US downgrade is worrying on several accounts, and in my view outlines further problems – both in the US and in world markets. On several accounts, this is purely disturbing, and on others highly dangerous. Lets dig in:
Lack of foresight when S&P put the writing on the wall:
C’mon, everyone: that the US would be downgraded by S&P was old news the second Obama signed the deal on August 2nd! S&P actually said they would downgrade onJjuly 14th unless the deficit could be reduced by US$4tn by 2021, and the deal is around US$2.5tn! Blaming S&P then would have made sense, unless everyone just want them to reduce the deficit by ways of talking high, and then reaffirm the rating anyway. These are the same institutions that got castigated from AAA’ing US housing CDO’s and CDS’s than no one even understood and was an extremely important lynch pin to the US housing market. I’m not saying that the analysis was right, but the punditry has shown that they’re willing to rip anyone that even breathes trouble for big, liquid markets and important institutions. Credibility issues either way you go! Hey, pundits/politicians/investors: next time, look a little bit further than your own nose, please!
Post-event political debate:
Didn’t the actual debt ceiling debate show how well political partisanship works for the US? It looks like they’re going to be much better at compromising in this super committee (How’s that for cartoonish?) when both parties appointed some of the most partisan people they could find… How the markets haven’t plummeted on this fact alone astonishes me.
Everyone was out criticising the ratings agencies in general, and S&P in particular, and bringing up their horrible track record since 2007 and onwards. I agree on the credibility point actually. My annoyance stems from not remembering the last time that anyone criticised the Big Three for undervaluing the creditworthiness of any issuer until after a downgrade or negative outlook. True, the times haven’t been particularly good, but seriously, if their credibility is only materially challenged by the punditry whenever they upheld ratings of (default-pathway) issuers, it speaks more to the quality of the pundits than anything else. Neither does this paint a pretty picture for the US. Cookies to whoever that can find anyone – ever – that berated S&P, Moody’s or Fitch for not raising the creditworthiness of any issuer. If anything, they’ve been late to the game of analysing credibility issues, and I am referring to the downgrade of sovereigns and housing mortgage providers here that were clear as daylight for a long time.
Now, what about Japan when they lost AAA as well? you say. Well, their yields went up, true, but that is because of the severe, structural domestic issues in Japan. Japanese people actually save, and don’t tend to like risk, so what is the result? Well, either the mattress, or the sub-1% yield on JGB’s. Sounds awful, but hey, when deflation reigns, cash is king, and JGB’s tend to be better than cash. The 5% gaijin investors are just along for the ride. Who wouldn’t be when the yen is a power train which is only beaten by the Swiss franc in terms of strength?
Commentary from business:
Warren Buffett went out on a limb and criticised S&P for the downgrade. Disturbing on several accounts: 1. Self interest. Anyone placing bets that Berkshire Hathaway isn’t stuffed with Treasuries? I’d gladly take them! 2. Self interest. Ok, the expectation for the Sage of Omaha’s opinion was something along the lines, but definitely not the volume of said opinion. Wonder why someone who essentially owns Moody’s Investor Services would take a stab at Standard & Poors…
This miraculously brings us over to the purely dangerous parts of the post-event commentary:
USA at AAAA? Funny!
Yeah, that’s seriously what Buffett asks, saying essentially that the US is the only true AAA. And why wouldn’t he, knowing full well that bond yields are near historical lows?
Because when the day of payment comes around, recent bond market moves says that a lot of other AAA countries will leave the US in the dust. Forget yield itself for a while, and look purely on the spreads. Half of Europe is out in front of the US with negative yield spreads! Take a look at CDS’s while you’re at it and ask yourself why a country that will essentially have to pay for the entire euro zone claims more clout than the US when it comes to creditworthiness in the market. Look at the Scandies, their currency appreciation and bond yields and tell me that foreign investors haven’t been buying whatever little they can off these shallow bond markets in export driven Lilliput countries. If you have to cite the market, please cite evenly as everything else mentions the spread to comparable economies. This comparison is far less forgiving to the US than its own history, and the only real way to stake a claim about the US AAA rating relative other countries. Also, why does the US bond market tend to rally comparatively stronger these times? Well, more cash around in US markets in general, and with all the latest regulation, no bank wants to be burned either financially or by the punditry and politicians for taking risks.
Times are uncertain, and that has led to bonds being bought by instinct, almost indiscriminately on their safety and liquidity properties, and thus yields have plummeted. Saying that the markets have faith in you because of that is like saying that you’re a great investor because you make a 5% profit when the index goes up by 15%. The truth is, the only way that a comparison says anything about the positive creditworthiness of the US government is to look at some Mediterranean issuers… Worse, if this is the prevailing mentality in the market (which, by the above spread argument looks unlikely) it could exacerbate strongly the adverse market moves as investors flock to an erroneous perception of safety. Yeah, I just said that the belief that US Treasuries are safe risks making the crisis worse. Here’s why:
US$2tn of drops in the ocean.
The Treasury blasted S&P with everything it had, claiming that they can’t do whatever basic math principle it was (pick exponential decay, division or addition) that caused a $2tn error in total deficits over a few years. S&P corrected it, found that this would correspond to 2% of GDP over the period concerned, and stuck to their decision. Let that sink in. Essentially, the budget deal that was made to raise the debt ceiling in a historic debate was dismissed as a drop in the ocean, a small assumption error and over the time frame used more or less irrelevant.
Now, imagine what happens if everyone piles into US debt because of the lack of confidence, and then there is an actual crisis, lets say a year from now (remember the narrative of the 2007 markets and why it took about 18 months to play out in full). If politicians can’t agree on this comparatively little, what is the political process going to do to investor confidence by then? I’d want to be net short US bonds if i could. I doubt they can go up substantially over the long term whether the economy tanks or rallies.