Tuesday, August 9, 2011

US Ratings Downgrade: The End Of The World Is Nigh! Again

I hadn’t touched a computer since last Friday, so I only heard the news Monday morning. While S&P’s move was a bit of a surprise, coming as it did on the heels of the agreement last week on the US debt ceiling, it wasn’t an absolute shocker. The magnitude of the US national debt – and more importantly, who’s holding it – suggests that the risk was always there.

Fundamentally though, nothing has really changed since last week or last month. I can’t help feeling that the ratings agencies are bolting the stable door after the horses have fled. They were roundly criticised and partly blamed for the CDO mess that caused the liquidity crunch in 2007-2008 – both in rating structured products at AAA grades as well as for failing to downgrade fast enough when it became clear that most of the stuff was junk. This is perhaps S&P’s way of saying never again, as the downgrade is a bit of a paper tiger.

What makes this all ironical is that because US government borrowing is all denominated in US dollars, the risk of default is effectively zero. Hence, I don’t know if there’s going to be any real impact on US debt issuance or investor appetite for US treasuries. Even as equities worldwide faced a sell-off, when I checked just now – as I suspected would happen – US treasury yields were down, not up as you would expect on a ratings downgrade. The news just provided investors an excuse to act on their fears over global growth, as equities have looked overbought to me and many others since early this year.

But flight to safety leads directly back to US sovereign debt. So you’ll have this paradoxical situation of the debt downgrade leading to higher demand for the very debt that supposed to be less credit worthy (and incidentally, higher demand for the USD). Go figure.

And before anyone starts blaming the Fed for treasury price movements, let’s note that QE2 ended last month and hasn’t been extended (yet). I’ll also note in passing that the ECB took the opportunity today to quietly expand their QE program, adding in Spain and Italy to the existing support they’ve extended towards Greek, Irish and Portuguese debt.

We’re truly living in interesting times.


  1. Hi I just found your blog. Makes interesting reads. I have a keen interests in Malaysian economics more an interests than anything.

    Not such why all the analyst are screaming Fed QE3. There not much bullets on the Fed side. The fact that the ECB came out buying junk bonds of Italy and Spain is already QE3 in progress.

    I also think the sell off is only part US ratings downgrade. The more immediate concern is the global slowdown that is already in place. Last 3 months data have shown either contraction if not stagnant industrial activities - the real economic activities - from US, UK, Euro, China, India and the smaller ones like S. Korea, Singapore, Taiwan.

    I feel a lot of people are not prepared for the dramatic global slowdown. That' is why we still see all the talks about a "2H 2011" recovery. When those in the 'recovery' camp dies off, I am afraid we are just going to get more bad news.

    Yes interesting times. However for the leveraged ons (knowingly or unknowingly) the time to sweat might be here to stay.

  2. "So you’ll have this paradoxical situation of the debt downgrade leading to higher demand for the very debt that supposed to be less credit worthy (and incidentally, higher demand for the USD)."

    The understatement of the international financial year, 2011 (also all the way back thirty years).

    Doff your hats and songkoks, gents.

  3. Msia IPI has been negative for 3 months now. Could you kindly explain what this indicates? Thank you

  4. @JW


  5. The risk of default is not zero. Due to the fact that the US needs to create new debt in order to pay for old ones, the debt ceiling mechanism (due to political wrangling) has the potential to effectively cause the US to default.
    Moreover, "defaulting" can be seen as two situations: (the standard definition) 1. actually not paying the interest/principal; (and the unofficial one) 2. causing the value of the currency to fall so much that the lenders end up with less value that they started with.

  6. Actually, historically, the "traditional" way the US has handled high official debt is through inflation - that's how it partly lowered the debt-GDP ratio in the post-WWII era. The other way to do it is through sheer economic growth. The forex implication is new because previously the last time the debt ratio was this high, most of it was held domestically.

    But, does anyone seriously think that Congress would ever allow a real default. Even the Republicans aren't that stupid.