The Absolute Return Letter
August 2011
Why U.S. of AA Matters
by Niels Jensen, Absolute Return Partners
We have never published the Absolute Return Letter before in August and, hopefully, we will never have to do it again; however, the unprecedented events of recent days and weeks have forced our hand. I will make it short, though. August is for reading, not writing.
Unless youâve spent the last few days on another planet you will know by now that Standard and Poors chose to downgrade U.S. sovereign debt to AA+ last Friday evening. A U.S. downgrade is, in itself, almost meaningless. A nation that issues debt denominated solely in its own currency and which is in full control of its monetary policy, cannot default unwillingly. Nations default because they run out of foreign currency to service their debt, but the U.S. doesnât need foreign currency to service its debt. One could thus argue that the rating agencies shouldnât even bother to rate U.S. sovereign risk. But they do. And one of them has now decided that U.S. sovereign is no longer AAA. So what does it mean? Near term, other U.S. financial institutions (Fannie Mae? Freddie Mac? JP Morgan?) will be downgraded as a result - perhaps as early as today or tomorrow. Following that, if Standard & Poors wants to maintain whatever credibility it has left, it will probably have to downgrade a few sovereigns as well. France springs to mind; it is not far behind the US as far as profligacy is concerned, and it may prove difficult for Standard and Poors to justify the AAA rating it currently assigns to France.
If France is downgraded, a number of French banks will almost certainly be downgraded, following which other European banks will face the same destiny. Such a scenario has the potential to cause calamity across Europe. The 90 European banks which recently went through the (socalled) stress test organised by the European Banking Authority need to roll a total of âŹ5.4 trillion1 (!) of debt over the next 24 months. A massive amount even during the best of times. Probably undoable during times of stress. As Ambrose Evans-Pritchard, in consultation with Willem Buiter of Citigroup, pointed out in the Daily Telegraph over the weekend2:
â...the issue is not how long Italy and Spain can ride out the storm in bond markets. There would be a banking and insurance crisis long before sovereign defaults came into play, simply because the fall in bond prices on the secondary market is causing carnage to bank books (among other transmission mechanisms).â
With its downgrade of U.S. sovereign debt, Standard and Poors has started a chain of events which can only make things worse in an already crisis hit eurozone. For that reason, the decision to downgrade was not only badly timed but also ill considered; that it was probably justified is of little relevance at the moment.
In another development this morning, the ECB has announced that it is expanding its bond purchasing programme to include the entire eurozone â thereby implying that it is now buying Spanish and Italian government bonds. The effect has been immediate with Spanish and Italian 10-year bond yields falling 60-70 basis points. European stock markets, on the other hand, are not visibly impressed. After an initial rally, most markets are now down as investors fret over the longer term growth outlook in the eurozone.
