Sunday, August 7, 2011

Don't worry darling, AA+ is the new black.

Of course the big news for he coming week is the S&P downgrade of the United States long term credit rating from Aaa to Aa+ with a negative outlook. To hear the financial press tell it, this is no big deal. AA+ is the new AAA, the new flight to quality assets are the old flight to quality assets or, as they say in fashion, black is the new black.

The arguments in favor of this take several forms. One is that the markets have largely priced this in. Another is that, the credit rating notwithstanding, the vast majority of holders of US Treasuries will continue to do so. Thus there will be no panic sell off in the US Treasury market and the impact on the funding costs for the US government may be muted. They also point to the example of Japan, another country which lost its AAA rating without a significant impact on its borrowing costs.

I think these arguments have some merit but I think the conclusion they reach is far too sanguine. I think this is the beginning of what will be a systematic repricing of risk assets which will demand higher returns and thus push asset prices lower.

I think the argument that there will not be a fire sale of US sovereign securities is correct. The largest holder of Treasuries are the government “Trust Funds” for Social Security and Medicare which should themselves be the subject of a blog post. Once the government realized that it would in no way be able to pay for future entitlement programs on a pay as you go basis on account of demographic changes it decided to try to minimize the burden on future taxpayers by charging an excess to current taxpayers. A reasonable idea except that the Trust Funds are mandated to be invested fully in US Treasury securities. That is to say the government lent the money it is saving back to itself to pay for programs today. Who has to pay these loans back? The very future taxpayers the government was trying to spare excess taxation in the future, more specifically, if you are a US national in the prime of your working life: YOU. Nonetheless, the Trust Funds are unlikely to sell their Treasuries.

The second largest holder is the Federal Reserve which owns a lot of Treasuries as a result of its program of Quantitative Easing. It won't be selling either. The next batch of Treasury holders are foreign Central Banks the largest of which manage their exchange rates vs. the dollar by sterilizing capital flows between the countries in order to enhance the competitiveness of their domestic manufacturers. These banks are sure as hell not going to sell their Treasuries because it would mean their industries would have to compete on a level playing field with the United States, they have no intention of ever letting that happen. Next in line are world financial institutions who hold Treasuries as part of their securities portfolios and often pledge them as collateral to their own central banks or to the various clearinghouses around the world which intermediate the financial system. This weekend the Federal Reserve said that it would not adjust the risk weighting on Treasuries which would have forced all the banks in the world to raise capital. Finally there are the worlds money market funds. They will not be forced to sell their T-bills because the short term US credit rating is unchanged. The only people who will be forced to blow out of their US Treasuries monday morning, or rather Sunday night when Globex opens will be money managers with a hard AAA mandate that cannot change it in time to allow them to continue to hold US Treasury securities. Within the universe of $11 trillion in outstanding US paper, these are not a lot of guys.

So the argument that there will not be a wave of forced selling in US government paper holds water. The idea that the markets have this priced in I think is a lot harder to take. It's actually pretty hard to speak for “the markets” but given that longer dated T-bonds jumped about 10% in the past week I certainly get the sense that investors were thinking that the US government was a lot safer a bet than virtually anything else they might have put their money into. As you could see from the market action on Friday the markets have been far more focused on the sovereign issues in Europe than in the US.

I also think the Japan analogy breaks down both on the fundamentals and the timing. Japan has a very high savings rate and virtually all JGBs are held domestically. As a result Japan is reliant on relatively tame domestic buyers to fund its debt and deficit. This is not even remotely the case for the US where around half of our debt is held by foreigners and, because of our extremely low savings rate we are very dependent on the marginal foreign buyer to fund the deficit and maintain the price of Treasuries. Then of course there was the context of the Japanese downgrade. This was back in 2001, true we were in a recession brought on by the collapse of an asset bubble but the banking system had not had a recent near death experience. There were not also multiple simultaneous speculative attacks against major OECD sovereigns. No, I think the US downgrade is likely to have a substantial impact.

It may just be that the impact is not on US Treasuries themselves. As the optimists in the financial press have been quipping the downgrade of US Treasuries might lead to a flight to a quality into... US Treasuries. As mentioned, black is the new black. That may well be but it is cold comfort for what S&P has just done is make it official that the US Treasury can no longer be regarded as a proxy for the risk free rate. It may well be the least risky thing out there but all that is saying is that every other asset in the world is also riskier than it was when Treasuries were risk free and therefore should be paying a higher return. If they should be paying higher returns that means that they should be priced lower. This is what I think will happen, a systematic repricing of risk assets the world over to take into consideration that the US Treasury, and therefore the anchor of the global financial system in general, is actually much riskier than has been assumed for most of the past 60 years or so.

I expect this to manifest itself in renewed, and far more aggressive, speculative attacks in the Eurozone, and not just the periphery. If the US is not AAA then surely France, Germany and the Netherlands, the core of the Eurozone are on shakier ground than was originally thought. If they are on shakier ground then what hope can there be for Italy and Spain, who will be reliant on them in the event of a major fiscal problem. If Spain and Italy are in trouble what hope can there be for Greece, Portugal and Ireland. I think there will be a renewed speculative attack across the Eurozone periphery and perhaps an attack on the Center itself. In the event that such an attack succeeds, the European banking system will take a major hit to its balance sheets at the same time as the Eurozone governments are under attack from their bondholders. Keep in mind that the European banks are all much larger relative to their governments than are US banks. A European style TARP would be almost impossible to initiate so a sovereign crisis in Europe that spread to the banking system could not be contained and would quickly spread to the rest of the world.

A major and durable correction in risk assets would probably also deter both consumption and investment decisions in the US which may well tip an already fragile economy into back into recession. Bond markets will also have to begin to wonder about the credit worthiness of all US corporations. After all the rhetoric is that the way to plug the fiscal gap is through increased taxation on businesses and capital which will systematically raise the costs on American business. Whatever impact this may have on future profitability there is only one direction for equity prices to go in order to take this additional risk into consideration: down. Additionally, the fiscal problems facing state and local governments are going to become much more acute as their ratings are also going to be in trouble and while there is no precedent for a US sovereign default there is a LOT of precedent for municipal default. Municipal default can also cascade if investors generally flee municipal securities.

So in short, the financial press may be right. AA+ may well be the new black. The finances of the US Government may not be too affected in the end. The problem isn't really there. The problem is that if what was once considered riskless no longer is, then everything risky should be paying more than it was. I think it will take the markets a period of weeks to absorb the new risk paradigm and in that time the instincts of the market will be to flee risk assets and reprice risk generally. The timing of this is not particularly helpful because of the multiple speculative attacks in Europe and the fragile US economy. So the US Treasury may not wind up paying higher rates, at least initially, but everyone else in the world may and this is manifestly not helpful.

AA+ may be the new black, but we had better prepare ourselves for the mean reds.


Anonymous said...

You are always 1 step ahead..

Ken said...

Actually, the longer form version of this article contains an in depth explanation of the role of US Treasuries at the worlds clearinghouses. There's just so much tactical stuff going on I barely have time to explain the strategic stuff.

Anonymous said...

What about the argument that all of this was inevitable, that we were due for a correction eventually (making a W), and that the downgrade is just a red herring?

Ken said...

I don't believe that anything is "inevitable" or that the markets move in order to complete some kind of pattern on a chart. We may have been due for a correction but 12% drop from the highs constitute one. This is a whole different ballgame in my opinion.