Ratings downgrade and the FX market
It still appears likely the U.S. will avoid a default and manage to raise the debt ceiling prior to the early August deadline but the market has to seriously consider the potential consequences of a ratings downgrade given the fact recent negotiations have gravitated to a smaller and probably unsatisfactory $1.5trn compromise and given that Moody’s and S&P have already placed the U.S. sovereign debt rating on review for potential downgrade, with S&P already saying the odds of a downgrade within 3 months has increased to 50% following collapse of talks on July 21.
Just how much dumping of Treasuries would occur on an historic downgrade is unclear, but a look at the objectives, possible constraints and motivations of various holders helps to recognize where there are certain mitigating factors that would lessen the damage, only partially. Foreign holders make up the largest portion of holdings at 46%, with three quarters of these held by official institutions. Foreign official holders are already in the process of diversification, but it is in the interests of the holders to do this gradually. Moreover, ongoing FX intervention is adding to the outstanding stock of reserve assets and these are still largely destined for the US. China could stop adding, but are not likely to engage in massive liquidation, given the lack of Asian debt alternatives, the security risks in European debt and the lack of depth to markets such as Canada. In general, the lack of viable alternatives that offer the liquidity and stability will be a huge constraint on fast moves by FOIs. Japanese debt is a poor alternative for Japan and a downgrade of Treasuries might be viewed as temporary by these institutions. U.S. Households own about 10% and this will be a wildcard, but it does seem likely the bad press and unprecedented nature of a downgrade will lead to some quick selling of Treasury holdings in this sector in favor of bank CD’s or even stocks. Many funds with investment grade requirements are dealing with averages, so they say they might be more likely to sell low quality bonds to bring up the average quality to the necessary credit standards. Pension funds and mutual funds have been positioned very defensively regarding Treasury holdings due to the low yields relative to inflation and the recent end of QE2. Recent rules to strengthen money market funds by requiring 30% in cash and Treasuries could backfire in avoiding ‘breaking the buck’. Fitch has noted MMFs hold $1.3trn in Treasury and agency short term debt with a rush to redemptions an important risk to monitor.
Despite the mitigating factors, the consequences look negative, as a rating downgrade by 1 notch would still leave the US on negative outlook. The initial reaction would be adverse for the USD, as risk aversion would increase, risking declines to stocks (a clear leader in the tepid recovery so far) and higher US government bond yields (circa 25bps). However, the reaction could be different across currencies pairs against the USD. European banks still have a large net need for USD funding, which could be hurt in a downgrade scenario – especially if money market fund redemptions are evident. Additionally, the initial reaction in the USD could fade, if an increase in risk aversion and market volatility is evident, which could mean that the USD bounce off the lows against European currencies. EM currency gains and JPY gains could be more enduring versus the USD in this situation.
I believe that a downgrade is inevitable, even if the illusory August 2 ‘deadline’ for a legislative deal is met. Confidence in the ability of the Federal government to manage its fiscal policy will be severely shaken. Initially, there are many money market funds and pension funds which are prohibited by their charters from holding any debt rated lower than AAA. This will be unloaded post-haste, driving yields up at all maturities. Impact on the USD will be severe, though not irreparable. The largest uncertainty lies in the political fallout following the downgrade.
Cheers and trade well.
Boy the stock market took a shellacking today after the deal was done. The negative implications of this fiscal package for our economy could be severe. JP Morgan’s Michael Feroli estimates the impact on GDP will be -1.75%. In the currencies, EURCHF has been absolutely crucified over the past week, but the USD has been relatively mixed through all this. If U.S. debt is downgraded, we will all suffer. The yield curve just keeps getting flattened, which is great for holders of long bonds, but terrible for bills.
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