After the Downgrade

In Monday’s big market sell-off, investors contended mainly with two stories: S&P’s US credit rating downgrade and the ECB’s Spanish and Italian debt purchase plans.

Two weeks ago, S&P threatened a US downgrade if a debt-ceiling deal did not contain $4 trillion in spending cuts. It did not, and S&P made good on its threat. In early press release drafts, they cited estimates of the US’s future deficits as the primary driver for the downgrade, but after discovering a $2 trillion miscalculation, they adjusted their reasoning. Thus, the final statement cited political factors, namely the debt ceiling debate’s “prolonged controversy” and “political brinksmanship” (in other words, it took too long and Congress was too divided).

But that politicians are ineffectual isn’t news (nor unique to the US). And their ineffectiveness says nothing about our creditworthiness. We won’t argue with the notion of an ineffective administration, but is the current one truly more feckless than Clinton’s? G.H.W. Bush’s? Reagan’s? Our current debt service costs are lower than during their administrations—and very similar to G.W. Bush’s. In fact, the cost to service our debt is lower still now—long-term Treasury yields fell after the downgrade—not what you’d expect if the market believed default risk were higher.

Before the downgrade, one major fear was a lower rating would mean banks would have to dump Treasurys and replace them with other AAA-rated securities. However, on Monday, regulators quickly assured banks (and those who transact with them) the lower rating will not increase Treasurys’ risk weighting. Instead, US debt retains its zero-weight in the global banking complex, allowing banks to hold as much as they like without raising additional capital. Thus, banks have no new incentive to dump Treasurys. Other entities that might otherwise be inclined to sell Treasurys due to rules requiring them to own AAA debt are small in comparison and will likely amend those mandates—keeping US debt their most viable option. Further, two of the three major ratings agencies (Moody’s and Fitch) have maintained their AAA ratings.

What’s more, surely major Treasury investors don’t rely on S&P (or Moody’s or Fitch) to determine whether they should own US debt. (After all, McGraw Hill—the company that owns S&P—has a market capitalization of about $11.5 billion, while China alone owns about $1.15 trillion in US Treasurys.) The decision to hold Treasurys is based on many factors, most notably the Treasury market’s depth and liquidity, which is unmatched. The US accounts for about 55% of all AAA-rated sovereign debt (given Moody’s and Fitch haven’t downgraded the US).

In our view, the more important story affecting markets is news the ECB plans to buy Spanish and Italian debt. It appears likely these debt purchases may be unsterilized (i.e., the ECB wouldn’t make offsetting asset sales to hold the monetary base steady), essentially amounting to quantitative easing. This apparent, sudden willingness to loosen monetary policy (the ECB has hiked rates this year while the Fed, BOJ and BOE have held), coupled with the focus on the supposedly stronger PIIGS, likely returns European concerns to the forefront.

Though investors remain worried about potential Spanish or Italian bailouts, both nations’ yields fell on the news (both are now well below 6%), which does seem to abate the likelihood they need EFSFunding in the very near term. This may have been the ECB’s goal since Germany remains against increasing EFSF capacity from €440 billion—if Italy and Spain were unable to contribute to the EFSF due to their own troubles, Germany and France would be stuck with 80% of the tab.

Overall, Monday’s volatility seems to be a confluence of these fears, not a marked deterioration of fundamentals, which we believe remain overall positive. Corporate earnings and revenues—the latter an important measure of global business health—remain extremely strong and above expectations. And though some economic data have softened, most metrics continue to reflect expansion. Steep market volatility is painful, but it’s a not-infrequent occurrence and not predictive of future market direction. We could see further retrenchment in what seems to us a bottoming period. But the recent rapid, massive sell-off seems unwarranted in our view.