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US rating downgrade. What does it mean?
I would like to share an interesting article that I received last night from Fidelity Australia that explains the market volatility that we have seen over the past few days.
The US rating downgrade. What does it mean?
Markets are turbulent following the decision by Standard & Poor’s (S&P) to downgrade the US credit rating from the highest possible level of AAA.
In the US, the S&P 500 Index fell 6.7% on Monday, the first session since the US credit rating was cut, but recovered much of that overnight when it rose 4.7% to finish at 1,172.53. Stocks rose overnight after the Federal Reserve said it would keep interest rates near zero through mid-2013. The Fed’s statement is its biggest attempt since November to spark the US economy that largely stalled in the first half of 2011. The US economy grew at an annual pace of 1.3% in the second quarter, after only expanding at an annual pace of 0.4% in the first three months of this year.
Yesterday, Australia’s S&P/ASX 200 Index rose 1.2% on talk of more Fed support for the US economy, to eradicate an early decline of 7.4%.
Why did S&P downgrade the US?
S&P reduced the rating on the US and placed its long-term outlook on negative because the agency is worried that "political discourse" has diminished the credit standing of the US - it warned that it could downgrade the US to AA in the next two years. It's worth noting that rival agencies, Moody's and Fitch, have maintained their highest ratings on US debt.
Still, the S&P decision is significant. The world’s appetite for US government bonds affects the level of interest rates consumers and businesses pay around the world. In the US, there are concerns the rating downgrade could lead to flow-on rating cuts for numerous US companies and states, driving up their borrowing costs.
Technically the implications of the downgrade have largely been nullified. The US Federal Reserve has reassured banks that it will continue to accept US Treasuries as collateral and that banks will suffer no capital penalties for holding US debt. The Federal Reserve stated that “the decision by Standard & Poor’s has no implications for the operations of the Federal Reserve’s discount window or the conduct of open market operations”.
Was S&P's action a surprise?
As global growth has slowed since 2008, the US' long-standing and expanding fiscal deficit has been of greater concern to the rating agencies and the recent debt-ceiling deal fell short of the measures S&P felt were needed to rectify the imbalance.
S&P's action is not wholly unexpected, because the rating company placed a negative outlook on the US in April this year. Many investors felt, though, that the privileged place that the US dollar and debt hold made the risk of a downgrade less than certain.
What does it mean in theory?
This action is recognition that the fundamentals supporting the risk of investing into paper issued by the US have deteriorated below what S&P believes is expected of a triple-A rated country. As a result, it is expected that over the longer term, investors should expect an additional risk premium to be priced into the yield curve of paper issued by the US government and related issuers.
What it does not mean is that there is imminent risk of the US not honouring its obligations; the US remains just shy of the top-most rating category at S&P and therefore is a fundamentally sound credit risk. Other countries (including Australia) have experienced similar downgrades in the past and been able to reverse them later with appropriate policy action. US Treasuries are the most liquid instruments and a source of safety in times of volatility and reduced liquidity.
What are the implications in practice?
S&P’s decision may have no immediate impact on interest rates. There is a risk however that yields might rise across global bond markets, although it is not certain yet where this might happen or by how much.
It is likely to have an immediate impact on confidence generally and could have a negative effect on the global economy and equities – although we do not yet know what the full extent will be.
It will probably strain relationships between the US and key trading partners, especially China, which own a large proportion of US Treasuries.
It will have significant implications for the 2012 presidential and congressional elections. The debt-ceiling deal that just passed Congress attempted to defer tax and spending questions until after the elections in November next year. This is no longer possible. S&P's statement highlighted the weak political process as part of its rationale and it is poised for a second downgrade within two years. This will loom over the election, as candidates and parties will be scrutinised on fiscal policy.
The downgrade will hasten the debasement of the US dollar.
Are there any positives to take into account?
There are some important things to consider when thinking through the consequences of the downgrade.
Even though the US has been downgraded by S&P, large holders of US debt have little incentive to sell. The US Federal Reserve is already a massive holder of US Treasuries through its asset-buying program known as quantitative easing. US banks, money market funds and insurance firms have to hold US debt to meet capital requirements and maintain liquidity. For now, central banks around the world will still use the US dollar as a reserve currency.
Good can come from the S&P downgrade, if this humiliation stirs Washington into action. Washington policymakers now know that the US is not immune to risk assessment and they must act responsibly to turn the course of their policy to favour a stronger fiscal balance. The negative outlook does leave open the possibility of further downgrades should the fundamentals look likely to deteriorate further beyond S&P's tolerances within the AA+ ratings band.
"The US is still triple-A. In fact, if there were a quadruple-A rating, I'd give the US that." Warren Buffett
Source: Fidelity Australia
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