s&p’s downgrade of usa’s aaa credit rating

8/6/2019 S&Ps Downgrade of USAs AAA Credit Rating

1/27

August 3, 2011

Naufa l Sanau l l ah [email protected]

S&Ps Downgrade of USAs AAACredit Rating


2/27

The USA AAA ratingWas it justified economically?Had the market priced in a cut? (How) will this technically affect supply and demand in the near

term?

Long term prospectsForeign creditor Treasury holdings

S&Ps rate cutWhy now?Miscalculations?White House vs S&PPolitical fallout

Potential trades

S&PS DOWNGRADE OF USAA AAA

CREDIT RATING


3/27

THE AAA RATING


4/27

US at minimal economic risk of default because: Debt is primarily denominated in domestic currency, of which the Federal

Reserve is a monopoly issuer

Recent accounting changes allow the Fed to buy securities and sell themin a higher interest rate environment without solvency issues (at least

near-term) Grim prospects for global growth li kely to keep borrowing costs

low near-term

Interest expense rising on federal level, could spread to state &local levels as well

Economically, default risk as close to zero as exists in thecurrent global financial system, strictly as a function of the Feds

capabilities

Ignoring the Feds unique position, the US economy probablydoes warrant a less than perfect credit rating

WAS IT JUSTIFIED ECONOMICALLY?


5/27

US INTEREST EXPENSE TO GDP

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Pc

oGDP

Year

State Local Federal Total


6/27

The markets reaction to the debt ceiling debacle and S&Pcredit rating downgrade watch was a repricing of growthrather than solvency

Prospects of austerity dampened growth expectations Demand for cash and liquidity also helped bid USTs up

significantly T-bill scarcity is giving banks a hard time to provide non-negative

yields on mass influx of deposits

Banks essentially seeing hot money temporary flows into safehavens

CME announced 50bps haircut on formerly risk-free billsalmost two weeks before S&P downgraded

Risk is selling off because of policy divisiveness and politicalinaction:

GOP vs White House/Dems Germany/core vs periphery

HAD THE MARKET PRICED IN A CUT?


7/27

S&P 500

April 18: S&P assigns

negative outlook to USA

AAA rating

April 29: Sarah Palin

says he l ls no to

raising the debt ceiling

July 14: S&P places USA

on CreditWatch negative,

says it could downgrade

credit as soon as within

the month

July 22: Obama-Boehner

negotiations collapse

July 31: Boehner releases

d e ta i l s o f p r op os e d

agreement, passed by the

House the next day, and

the Senate the day after

that


8/27

10YR TREASURY YIELD

April 18: S&P assigns

negative outlook to USA

AAA rating

April 29: Sarah Palin

says he l ls no to

raising the debt ceiling

July 14: S&P places USA

on CreditWatch negative,

says it could downgrade

credit as soon as within

the month

July 22: Obama-Boehner

negotiations collapse

July 31: Boehner releases

d e ta i l s o f p r op os e d

agreement, passed by the

House the next day, and

the Senate the day after

that


9/27

For risk-based capital purposes, the risk weights for Treasurysecurities and other secur ities issued or guaranteed by the U.S.

government, government agenc ies, and government-sponsored

entities will not change. -Fed/OCC/FDIC/NCUA

Funds with risk mandates can stil l consider US Tsys AAA until : S&P cuts the credit rating further (the rating does carry a negative

outlook requiring substantive action in order to maintain AA+)

Moodys and/or Fitch also cut the USs long term rating (unlikely inthe near term)

A+ rating maintained on short-term debt means ratings cut is norisk to money markets

Effects do exist in terms of risk modeling There are immediate operational consequences, from re-coding risk

and trading systems to evaluating collateral and liquidity

management.Mohamed El-Erian, PIMCO

(HOW) WILL THIS TECHNICALLY AFFECT

SUPPLY AND DEMAND IN THE NEAR TERM?


10/27

UK & France will be in markets scope for imminent S&P downgrades;US downgrade may spark sell ing in French & UK govys

With Frances markets further deteriorating, Germany will be unable tobear the brunt of the costs required to backstop Italy and Spain

ECB looks increasingly l ikely to be lender of last resort here; S&Pdowngrade could be catalyst for i ncreased ECB involvement/

intervention in European debt crisis

I f ECB does not come introduce large-scale measures, the Europeansystem may face acute stress and countries may approach insolvency

I f UK yields start r ising based off of fresh credit rating downgrade risk,negative implications on growth in a fiscal austerity environment could

lead to Bank of England renewing easing rhetoric in forthcoming

opportunities

Renewed downgrade risk premia in munis? Dollar l iquidity l ikely to remain t ight and possibly t ighten further; crash

risk is high

(HOW) WILL THIS TECHNICALLY AFFECT

SUPPLY AND DEMAND IN THE NEAR TERM?


11/27

GLOBAL SHORT-TERM LIQUIDITY

TIGHTENING?

Foreign f inancial CP outstanding vs US Dol lar T WI ( inverse)


12/27

Recalibration of safe havens, which was a theme inmy piece from last week, is likely in play even more so after this

ratings downgrade

More flows into precious metals and CHF as safe havens Long-term flows out of USD-denominated assets Risk premia should also spread to other AAA rated countries in

danger of seeing a ratings downgrade from S&P, eg France, UK

Likely to be very bearish for banks and insurance firms Likely to have large cultural and societal implications

Public frustration with economy spiking just as Congressionalapproval plunges

The center is increasingly distanced from both partiesWestern nations now also seeing popular discontent with

government and authority, eg Tottenham riot

LONG-TERM PROSPECTS


13/27

Also sets up for pervasive reassessment of the role played by creditrating agencies in the financial system

The AAA downgrade could end up being a tr igger that sets of f a newdynamic rebalancing of r isk on a longer term, gradual perspective; shift

from risk-on/risk-off to high growth/low growth (growth with respect to

GDP)

Is the USD stil l a safety asset? Is it st i l l going to be in demand duringflights to quality/safety?

Risk of China dumping bonds is minimal Chinas UST holdings are a function of its trade policy/growth model, not

a directional investment

With the USs AAA ratings downgrade being more acutely bearish forEurope than America, what other liquid instruments can be used to

diversify out of USD?

Will this go down as a Sputnik moment or the harbinger of a structuraldecline?

LONG-TERM PROSPECTS


14/27

S&PS RATE CUT


15/27

April 18: We believe there is a material risk that U.S.policymakers might not reach an agreement on how toaddress medium- and long-term budgetary challenges by2013; if an agreement is not reached and meaningfulimplementation is not begun by then, this would in our view

render the U.S. fiscal profile meaningfully weaker than that ofpeer 'AAA sovereigns. S&P

July 14: The CreditWatch placement of the U.S. sovereignratings signals our view that, owing to the dynamics of thepolitical debate on the debt ceiling, there is at least a one-in-two likelihood that we may lower the long-term rating on theU.S. within the next 90 days.S&P

The politics of DC and the debt ceiling timeline are what drovethe timeline of S&Ps announcements as well

WHY NOW?


16/27

S&P released a judgment aboutthe credit rating of the U.S. that

was based on a $2 tril l ion

mistake.John Bellows, US

Treasury

After acknowledging the error,S&P removed a prominent

discussion of the economic

justif ica tion from their

documentand refocused the

downgrade argument on the

polit ics Implications on debt/GDP ratios

displayed on the chart to the

right, courtesy of the US

Treasury

MISCALCULATIONS?


17/27

In April, Secretary of the Treasury Timothy Geithner saidthat there no risk of downgrade of the USs AAA rating

The Treasury is directly attacking S&P over its ratingsdowngrade and mathematical error

The GOP is likely to use the downgrade as a focal pointaround which to blame the Obama administration for

economic woes

President Obama and the White House are likely to passthe blame off to S&P and rally around negative populistsentiment of credit rating agencies

WHITE HOUSE VS S&P


18/27

Dodd-Frank had negative implications on CRAsIn March, congressional Republicans launched the

first real push for Dodd-Frank reform, including a

proposal to limit CRA liability on previous rat ingsWhite House and Democrats likely to frame debate

around the merits and roles of the CRAs and try to

de-legitimize the downgrade

Look for the political rhetoric to heat up further

WHITE HOUSE VS S&P


19/27

Because of the increased risk premia that the UK and Francewill now face as a result of US losing AAA, a coalition of such

nations could begin an attempt at fundamental reform of theCRA industry to minimize their ratings impacts

CRAs likely to face even more populist frustration & blameand regulatory uncertainties than they face presently

Likely to have implications on munis; potential downgrades instate & local debt are possibly imminent

Political fallout of rating cut likely to be more acute in Europe Emergency calls being held by ECB & G20

Coordinated policy response before market open?Will the ECB relent on its hawkish policy?

Because of the knock-on ef fects to France, the EFSF findsnewfound funding uncertainties

POLITICAL FALLOUT


20/27

German government is already saying Italy is too big for an EFSFbailout and that an Italian bailout would negatively affect

German finances

This is Germany posturing against unilateral backstopping ECB may have to convert its stopgap plan of SMP Italian bondpurchases into a much larger, more pervasive, unsterilized one ECB could always cut rates as wellwhich the Germans may be

more willing to al low, as it is a better alternative to Germany

bailing out the rest of Europe itself

Still, Bundesbank President Jens Weidmann is opposed to bondpurchases

This sets up for the potential for an acute monetary crisis thatcould destabilize markets

With Weidmann and Stark opposing bond buys, are weapproaching a breakdown/inflection point?

POLITICAL FALLOUT


21/27

Asia may not be behind the periphery bid without ECBbackstopping the market and system

A return to the Deutsche Mark at a fixed exchange rate tothe Euro has been another idea making the rounds that

may become more realistic as the European crisisintensifies

With Italy sovereign credit rating review by S&Pforthcoming, the European crisis is becoming more acute,

especially with the prospect of a double notch downgrade

of Italian debtUS AA+ rating is on negative outlook as well, so status

quo insufficient for maintaining AA+ from S&P

Similarities to 1937-38 global double dip increasing

POLITICAL FALLOUT


22/27

Downgrade bodes poorly for the already increasing divisivenes sbetween political parties

Obamas action on Geithner will be scrutinized Geithner recently wanted out and Obama convinced him to stay onboard Post-downgrade, there are already calls from GOP politicians to fire Geithner Obama may have to double up on his bet on Geithner in order to shift blame

of the downgrades implications on the GOP and S&P

Jon Corzine potential replacement for Treasury Secretary? What will be the regulatory impact on C RAs? Will the Fed, BoE, or ECB announce easing going forward? What will Congress do between now and November 23/December 23

(deadlines for agreement on additiona l BCA savings and for

Congress to pass them)?

Government debtor vs creditor divisiveness going forward?

POLITICAL FALLOUT


23/27

POTENTIAL TRADES


24/27

All of these trade ideas are invalidated in the event of a largeenough scale policy response from G7, G20, or ECB before markets

open Sunday night

Safe haven repricing Long precious metals Long CHF (vs USD, EUR, GBP, JPY) Long big-cap multinationals with large cash reserves (especially ones

with dividends)

Knock-on effects for Europe Short European banks and insurers Short EUR (vs USD, CHF, JPY) Long CHF vs HUF, PLN Long periphery debt on yield spikes (once/if reversal back down is

underway)

Short bunds and French govys vs long USTs

POTENTIAL TRADES BASED ON THE US

SOVEREIGN RATING DOWNGRADE


25/27

UST bid, but longer-term credit risk risingLong 10s30s bull steepenerLong short end of Tsy curve

Financial system weaker without AAA rating to back itsmost liquid reserve and funding currency/regulatory

uncertainties for financial sector

Short BAC, C, WFC, GS, JPM, STT, MSShort MHP, MCO

Deteriorating prospects for government expenditures andinvestment globally

Short coal and steel equitiesShort copper and AUD

Short shipping equities

POTENTIAL TRADES BASED ON THE US

SOVEREIGN RATING DOWNGRADE


26/27

CHARTING 10YR NOTE FUTURES


27/27

CHARTING 30YR BOND FUTURES

s&p’s downgrade of usa’s aaa credit rating

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