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Investment Research
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General Market Conditions
Standard &
Poor’s
(S&P) on Friday downgraded the US sovereign credit ratingto AA+. The outlook was kept at negative as the rating according to S&P couldbe lowered to AA within the next two years if US cuts spending less than agreedto or other factors result in a higher trajectory for government debt. The ratingaction was in line with our expectations as stated recently in
–
both financial and corporate - are likely tofollow on Monday according to S&P. Fannie Mae and Freddie Mac, the USmortgage giants, are among others likely to see a rating downgrade.Renewed market turmoil is likely to be followed by a strong policy response fromFed this week in terms of new policy stimulus and ECB might use new Italianmeasures to cut the deficit faster as a fig leave to step in and buy Italian bonds tostop the crisis in euro debt markets. This could turn market sentiment morepositive during the week.The total effects of the downgrade, however, are overall very uncertain as theripple effects from potential systemic factors are fairly unpredictable. Hence aworse scenario could also materialise.S&P refers to the recent fiscal plan which it does not find ambitious enough andfalling political effectiveness makes S&P pessimistic politicians can come up witha plan that solves the medium- and long-term challenges to US debt.The action from S&P will only add to financial uncertainty and we expect anegative reaction of a total of 5% on equities and we expect it to add 10-15bp toUS bond yields.
The downgrade is all else being equal dollar negative. However, a possible sell-off in risky assets would mitigate the negative effects on the dollar and we could seethe dollar gaining against the cyclical currencies, e.g. the commodity, EMcurrencies and Scandies that are sensitive to risk aversion. A risk-off marketreaction could also push EUR/USD lower.Last night it was announced that the ECB will actively implement its SecuritiesMarkets programme (SMP) and henceforth buy Italian and probably alsoSpanish bonds. The announcement is the first in the strong policy response to theongoing crisis and should mitigate any negative effects on the markets.
Downgrade adds to uncertainty
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will weigh more on equities
The downgrade of US debt comes at a very critical time for financial markets. The market
tensions are already very high following last week‟s disappointment that ECB would not
buy Spanish and Italian bonds to help reining in recent sharp rises in bond yields of thesecountries.
08 August 2011
Important disclosures and certifications are contained from page 4 of this report.
Flash Comment
US downgrade adds to financial uncertainty
Chief Analyst
Allan von Mehren+45 45 12 80 55alvo@danskebank.dk
2 | 08 August 2011
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Flash Comment
A better-than-expected US job report failed to turn sentiment in a sign that markets werestill very nervous. And the downgrade will only add to uncertainty in a very fragilemarket.So what to expect? As we wrote in
ourmain scenario is that it will cost 5% on equity prices and 10-15bp in terms of higher USbond yields. That said, most of the direct impact on US Treasury yields from thedowngrade by S&P was probably already seen on Friday. The rumours that hit the marketshortly after the payroll data were released probably explain why equities traded sidewayswhile yields rose. Hence, today Treasury yields will mostly trade on risk appetite andEuropean events.The market reaction will also depend on the global policy response in coming days to themarket turmoil. Tuesday we expect Federal Reserve to add new stimulus measures tofight the confidence crisis in the markets and underpin the ailing US recovery.Last night ECB released a
“
It is on the basis of the above assessments that the ECB will actively implement its Securities Markets Programme. This programme hasbeen designed to help restoring a better transmission of our monetary policy decisions
–
taking account of dysfunctional market segments
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and therefore to ensure price stability
in the euro area.”.
This statement was released following a conference call last night forthe euro area central bank governors. Neither Italy nor Spain are mentioned specificallywhen referring to the SMP, but that would also break with the ECB tradition.As we wrote last week (see
), weexpect the ECB will begin purchasing Italian and Spanish bonds if the pressure increasesfurther. It is our expectation that this will happen today probably starting around 10.00CET. Given the reaction we saw in May 2010, we should be in for a significant spreadcompression between the periphery and core-EU. The buying should also mitigate thecurrent risk-off sentiment seen in e.g. Asian stock markets this morning.
Worse case scenario of downgrade is systemic ripple effects
A worse scenario than a 5% decline in equities can also be envisaged if systemic risks areunderestimated. These risks are described in the abovementioned research paper andinclude potential forced selling of US treasury bonds from funds that can only invest inAAA paper and negative implications for money markets as US treasuries serve ascollateral in many OTC trades. Downgrades of US financial institutions could also triggera negative rating spiral in which funding becomes more expensive for these institutionsand subsequently triggers further downgrades.These potential ripple effects are very difficult to predict but add to the uncertainty of thepossible impact of the downgrade. These effects may be dampened by the fact that
Moody‟s and Fitch still ha
ve a AAA rating for US debt as many funds are only forced tosell if more than one rating agency changes the rating.
Motivation for US downgrade
Fiscal plan not ambitious enough
: S&P writes that “the downgrade reflects
our opinion that the fiscal consolidation plan that Congress and theAdministration recently agreed to falls short of what, in our view, would benecessary to st
abilise the government‟s medium
-
term debt dynamics”.
Weaker political effectiveness
: S&P continues that “the downgrade reflects our
view that the effectiveness, stability, and predictability of Americanpolicymaking and political institutions have weakened at a time of ongoing
3 | 08 August 2011
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Flash Comment
fiscal and economic challenges to a degree more than we envisaged when weassigned the negative outlook to the rating on April 18, 2011. And S&P is
“pessimistic about the capacity of Congress and the Administration to be able toleverage their agreement this week into a broader fiscal consolidation plan...”
So bottom line is that the fiscal plan was not ambitious enough and S&P doubts thatpoliticians are able to come up with a plan that can meet the medium-term challenges.
Uncertain how the downgrade will affect the dollar
The downgrade attaches a higher risk premium to US assets and we should
–
all elsebeing equal -
expect to see the US dollar depreciate against the other „reserve‟ currencies –
the Swiss franc, the yen and most likely also the euro. We already saw EUR/USDmoving higher on Friday as the downgrade rumours started to hit the market.A possible sell-off in risky assets would, however, mitigate the negative effects on thedollar. We could even see the dollar gain against not least the cyclical and also risk sensitive currencies (e.g. the commodity, EM currencies and Scandies) if the shock to risk sentiment is large enough.A bigger sell-off in risky assets coinciding with general deleveraging could also lead to arapid unwinding of speculative short dollar positions (which according to IMM data havebeen building over the past month), which will also support the dollar.EUR/USD is also expected to get support from the decision by the ECB to re-activate theSMP. The decision should remove some of the current risk premium attached to the euro.For more on the effect on the dollar of the downgrade see
. All in all, we are reluctant to recommend selling the dollar on the downgrade as anyinitial sell-off in risky assets will be dollar-supportive.The traditional safe-haven currencies CHF and JPY should benefit from capital inflow.Hence, a new round of intervention on FX market from BoJ and probably also the SNBcould be imminent, if the currencies appreciate strongly.
Strong reaction from China
China issued a fairly harsh statement following the downgrade blaming the US forcreating its own mess.
“The US government has to come to terms with the painful fact that the good old days
when it could just borrow its way out of messes of its own making are finally g
one,” thestatement said. “China, the largest creditor of the world‟s sole superpower, has every right
now to demand the United States address its structural debt problems and ensure the
safety of China‟s dollar assets
. International supervision over the issue of US dollarsshould be introduced and a new, stable and secured global reserve currency may also bean option to avert a catastrophe caused by any single country.
”
The downgrade is thus increasing tensions between the
world‟s
two largest economicpowers which is only adding to uncertainty.
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