US Sovereign Credit Rating Guidance Revised Downward To Negative: What Are the Implications?

This is significant despite attempts by the government and the financial industry to claim otherwise. The loss of AAA status affects purchase of US-backed securities because many funds and governments require a certain percentage of securities of that quality in their portfolios.

This post is comprised of two articles. The first, by Brad Delong in the Financial Times offers a macroeconomic and political perspective. In effect, this is a warning that a debt reduction budget deal is important - more so than scoring ideological points from the right wing radicals. In the second piece, Barry Ritholtz at Big Picture provides a trader's perspective:

"A spokesperson for Standard & Poor’s said on Monday that there was an “at least a one-in-three likelihood” that the rating agency “could lower” its long-term view on the US within two years. US equities quickly dropped by more than 1.5 per cent. Importantly, however, the dollar did not weaken and US Treasury interest rates did not rise. The reason for this unexpected pattern is simple: the markets think this move is important not because it signals something fundamental about the economy, but because of the political impact it will have in Washington.

So what is going on? A sovereign-debt downgrade is supposed to mean that a government’s finances have become shakier. This means that the likelihood of internal price inflation is higher, the future value of the nominal exchange rate is likely to be lower, and the possibility that creditors might not get their money back in the form and at the time they had contracted for had gone up.

But if this were true the value of the dollar should have fallen on Monday. At the same time nominal interest rates on US debt should also have risen. The value of equities, meanwhile, could have gone either way: macroeconomic chaos would diminish future profits, but stocks have always been and remain a hedge against inflation.

But that is not what happened here. Instead equities fell, the dollar rose, and nominal Treasury interest rates were unchanged. Given this, there are two things to bear in mind. First, you can go insane trying to over-interpret short-term market movements. Second, news comes in flavours: new news, old news, no news, and political news. And it is important to understand which type this was.

If S&P’s announcement were genuine “new news” to the market, we would have expected to see the standard pattern: equities down, dollar down, rates up.

Meanwhile, if the announcement were old news, we would have expected to see no price movements at all – the smart money would already have taken up their positions. Equally, if it were no news – if the market as a whole simply thought that S&P was irrelevant – then we would have expected to see no price movements at all. But this did not happen: we did see price movements, both in equities, and in the dollar.

Instead what we saw just what might have been expected to see if S&P’s announcement is seen not as a piece of information produced by a financial analyst studying the situation, but instead as a move by a political actor trying to nudge a government toward its preferred policies.

Why? On Monday we saw confidence in the US, and the dollar as a safe haven, strengthen. This means that some who were previously leery of keeping their money in dollars, out of fear of future depreciation, are now less leery. This means some in the markets expect the S&P announcement to be successful as a political intervention. In short, the market thinks the S&P has just increased the chance of a long-term budget deal.

Monday’s pattern makes sense, therefore, if S&P’s announcement is seen as a political move. The market reaction sees Congress like a mule: it only moves when hit with a whip. Normally the whip to get a deficit-reduction deal is fear of the bond market’s producing a spike in interest rates and borrowing costs, but perhaps a fear of a ratings downgrade will do instead. Over the next few months we will see if the market is right.

Ritholtz, The Trader's perspective:

"S&P’s revision to the outlook on the United States’ sovereign credit rating to negative from stable this morning provoked a wide range of reactions. Not terribly significant in the sense that the outlooks on issuers’ credit ratings are revised up and down by the ratings agencies every day, and not terribly significant in the sense that the markets didn’t move all that much, the revision has nonetheless touched a nerve. Why?

For starters, it is the first admission by what I call “officialdom” that the means by which we extricated ourselves from the debt deflation of 2007-09 carry negative consequences. Who knows if the big swings in the market are caused by shifts in the dominant narrative or whether the narrative shifts in response to the swings in the market, but either way today’s action by S&P introduces a new narrative into the mix. This crisis isn’t over; it’s just entered into a new phase. This was never a mere cyclical recession anyway and now we have a choice: tighten our belts to preserve our preeminent financial standing in the world, or roll the dice on further policy accommodation at the risk of the a debilitating, Greece-like implosion.

That’s a far cry from the present dominant narrative which goes something like this: Short-termism of the kind displayed during last December’s “budget compromise” is irresponsible and will cost us dearly at some point, but it also symbolizes policymakers’ desire to do “whatever it takes” in the short term in order to keep this recovery going.

Secondly, should an actual downgrade of the U.S.’s issuer rating to AA+ materialize, and should it be followed by downgrades by Moody’s and Fitch, there are all sorts of question marks about what kind of friction would result from institutional rigidities. For example, many institutions around the world have mandates to invest certain percentages of their funds in AAA securities. Presumably, downgrades by two or three of the agencies would spark a good deal of selling by those institutions.

What about Treasuries’ hypothecation value? If they’re not AAA anymore, would they be accepted as collateral in the repo market on the same terms that are offered today? Or, would extra collateral need to be posted – or would the interest rate charged need to rise? What effect would this have on liquidity, on the very “money-ness” – to borrow Doug Noland’s term – of Treasury securities? Likewise, 100% hypothecation value is the essence of risk-free, and risk-free is the essence of moneyness. In Minskian terms, a decline in the moneyness of Treasuries would make it more difficult for levered entities to “make position” which in turn would make the financial system more fragile, more susceptible to crises.

I’ll go one step further: this revision, this oh-so-minor revision, is in fact a policy tightening. Despite the fact that several additional steps would need to be taken by the ratings agencies before any of these liquidity difficulties came to pass, I believe that the shock of today’s announcement amounts to a more significant policy tightening than that which will occur in June when the Fed ends QE2. The end of QE2 is part of a carefully prepared script and therefore will have no real impact on market participants’ behavior (by design). Besides, quantitative easing produces diminishing returns (it puts cash assets on banks’ balance sheets, enhancing their ability to make position, but relaxed FAS 167 guidance has already alleviated any difficulty in making position by absolving the really bad assets from mark-to-market accounting) which means that ending QE2 will not be significant in the context of financial sector liquidity.

The implied yield difference between 3-month Eurodollar futures and the 3-month overnight index swap (a proxy for interbank lending risk) on an intraday basis going back about a year show the yield difference spiked about 3 basis points higher on the heels of S&P’s announcement this morning.

It’s not an insignificant move, that 3 basis point spike. If I’m right and S&P’s announcement does in fact constitute an actual policy tightening, it either hasn’t hit full bore yet or it’s simply a very slight tightening. This context is important because even the cleverest theories amount to nothing if there’s no follow-through in the markets.

However, if, after the political and financial establishment gets done telling us all to quit our worrying and that today’s action by S&P has no practical significance, traders get to thinking about the very real implications this action has for financial instability in the future (and traders are forward-looking, right?), we might be looking at a downside catalyst for risk assets including stocks.

It’s a testament to traders’ undying optimism that the market managed to pare nearly half of its losses in the afternoon.