Friday, May 22, 2009

Nothing to see - until there is.

From Alphaville:

Sovereign downgrades: some perspectives

In the aftermath of S&P lowering its outlook on the UK from stable to negative due to the country’s rising debt levels, there has been a flurry of commentary from analysts, other ratings agencies and (inevitably) political journalists.

And of course, there’s been a market reaction - while the sterling has regained its footing, in late trade in the US on Thursday, the US dollar, bonds and equities were facing severe selling pressure

What hurt sentiment across the pond was the fear that the US, too, is vulnerable to the loss of its triple-A credit rating. As David Rosenberg (formerly of Merrill Lynch, newly of Gluskin Sheff) put it in a note on Thursday morning:

Don’t think for a second that the same cannot happen to the USA at some point judging by the massive runup in government debt and debt guarantees.

Pimco’s Bill Gross told Reuters much the same thing after markets started to slide, i.e. that investors fear the US is “going the way of the U.K. — losing AAA rating which affects all financial assets and the dollar.”

Which is an exaggeration - a negative outlook is hardly a downgrade - but Gross may well have a point.

Analyst Alan Clarke at BNP Paribas noted that in some cases (like Ireland) “the progression from outlook negative to downgrade can still be just a matter of weeks.”

On the other hand (emphasis ours):
The Irish experience reflected a sharp deterioration in conditions over a short space of time. For the UK, it is likely that the bulk of the bad news has largely surfaced; it is now a case of whether or not it looks like the situation will be fixed in a timely manner. That implies a much longer review period than we saw in Ireland. Nonetheless, this week’s news does represent a step closer to a possible downgrade.

Clarke also provides a handy breakdown of the speed with which other countries have moved from a negative outlook or CreditWatch negative to an actual downgrade:

BNP Paribas table showing past experience of sovereign downgrades

Moreover, in the case of the UK, “the election is the key to reassessment.” As a result, Clarke thinks the base case for the timing of subsequent rating action, “at least from S&P”, is around the time of the election.

However, he argues, there is a risk of a much earlier rating action:

This could be triggered by a failed gilt auction, a run on sterling, even worse than expected data on public finances in the near term or another bailout event.

Of these, he says, a failed auction or another slump in sterling are probably the biggest risks.
Overall, the change in the S&P outlook represents a shot across the bows for both political parties: either plan to get the public finances back in order after the election, or face a downgrade.

They conclude that while is it not inevitable that the UK is downgraded, the possibility remains a threat between now and next year’s election.

In any event, some commentators were little moved by the prospect of a sovereign downgrade for the UK or the US. Arguing for the Brits was Michael Riddell of the Bond Vigilantes blog, who noted:

So does it matter if the UK does eventually get downgraded to AA? Judging by [Thursday morning’s] very successful UK government bond issue, not much. The UK’s Debt Management Office issued £5bn of UK gilts maturing in 2014, and the issue attracted bids for 2.6 times the amount offered. This was impressive considering that, as RBC have pointed out, it was the biggest ever nominal amount of bonds sold in a single operation.

Also, a credit rating downgrade doesn’t necessarily mean government bond yields will rise - Moody’s downgraded Japan to A2 in June 2002, which was lower than the credit rating of Botswana at the time, and that didn’t stop 10 year Japanese government bond yields getting to 0.4% in May 2003.

On the other side of the Atlantic, Felix Salmon postulated that the US triple-A was “nothing to worry about”. Salmon takes the increasingly common approach of dismissing the prognostications of ratings agencies outright:
The most important thing to remember here, however, is that ratings agencies don’t matter any more. They lost their credibility when structured finance blew up, and the number of people buying Treasuries because S&P says that they’re triple-A rated is exactly zero.

And adds:
There are lots of triple-A rated securities; people buy Treasuries because they’re liquid. The US triple-A may or may not disappear at some point, but if and when that happens it’ll be a lagging indicator, and there will already be a select group of alternative securities which are trading at lower yields in dollars. So long as Treasuries have the lowest yields in the dollar-denominated world, they will retain their triple-A, and there are much more important things to worry about.

Which is, in a sense, precisely the stance taken by Her Majesty’s Treasury, one that translates to “move along people, nothing to see here.”

Timothy Geithner, at least, is attempting to dissuade markets of the likelihood of a similar threat to the US, telling Bloomberg Television that reducing the spiralling US deficit was “critically important”:

May 21 (Bloomberg) — Treasury Secretary Timothy Geithner said the Obama administration is committed to reducing the federal budget deficit after concerns rose that the U.S. debt rating may eventually be threatened with a downgrade.

“It’s very important that this Congress and this president put in place policies that will bring those deficits down to a sustainable level over the medium term,” Geithner said in an interview with Bloomberg Television. He added that the target is reducing the gap to 3 percent of gross domestic product or smaller, from a projected 12.9 percent this year.

Nothing to see - until there is.

Related links:
The sovereign ratings on the wall - FT Alphaville
Sovereign stress, UK edition - FT Alphaville
Fitch cuts Ireland to AA+, outlook negative - FT Alphaville
Portugal, Italy, Greece, Spain to S&P slaughter - FT Alphaville


Don the libertarian Democrat May 22 15:54
There is a conundrum in relying upon these ratings agencies, especially when rating countries. When I looked up the methodology that they used to determine these ratings for countries, I seem to remember thinking that they were a bit on the subjective side, including factors like, as you say, their assessment about who's running the country.

Now, I don't particularly trust ratings agencies to rate simple investments with clear guidelines, let alone giving them credence in the subjective realm of rating investments. Am I wrong about how they create this rating?

By the way, if people use it, it's hard to claim that it's worthless.

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