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Thoughts on the U.S. Sovereign Debt Downgrade
So much for a quiet summer weekend! Standard & Poor’s (S&P) announced early Friday evening that it downgraded U.S. sovereign debt from AAA (highest possible rating) to AA+. Since that time, I have observed much scaremongering in the mainstream media. I therefore felt compelled to share my thoughts as they pertain to the investment implications of S&P’s action. Analyzing the last several hours of trading from Friday, one can see that longer-term Treasury rates jumped by roughly 10 basis points (0.10 percentage points) when rumors of action by S&P started to emerge. We may expect to see a continuation of rising rates on Monday as the market absorbs the downgrade, but higher rates may stem more from the European Central Bank’s recent (Sunday afternoon) announcement that it’s stepping up purchases of distressed sovereign debt in the European periphery. Since U.S. Treasuries have benefitted from the flight to safety away from troubled European debt markets, it is reasonable to expect some capital to leave the Treasury market and to reenter European debt markets. Even though longer-term Treasury rates may rise during the very near term, I continue to believe they will drop from current levels over the next several months because: 1) S&P did not really tell bond investors anything new. Despite the initial market reaction, I do not believe longer-term Treasury rates will rise materially during the next few months because S&P did not tell informed bond investors anything that they did not already know. U.S. government bond and economic data are readily available and highly transparent to the general public, and so rising U.S. deficit and national debt data are not a closely held secret. In spite of the deteriorating fiscal picture, Treasury bond yields have been declining (and prices rising) since February. And since July 1, the 10-year Treasury yield has fallen from 3.20% down to 2.45% this past Thursday. Please read directly below for the main reason why Treasury yields have dropped.

Lederer PWM cannot guarantee any of the forecasts presented in this document.

2) The U.S. and global economies face near-term growth challenges, and fiscal stimulus appears politically impossible this year. With tepid U.S. economic growth in the post-financial-crisis environment, government spending would traditionally be looked to as a way to stimulate short-term aggregate demand. However, rising deficits and debt (and now the downgrade) have made it much less politically feasible for U.S. policymakers to implement another round of fiscal stimulus. Following the recent debt-ceiling debate, it is clear that government spending is not going to play a meaningful role in spurring higher economic output anytime soon. At the same time, many emerging-market economies are slowing down as they combat inflationary pressures. Meanwhile, Europe teeters on the brink of recession due to problems in the peripheral countries. Thus, it may be difficult for the United States to generate meaningful export growth through the remainder of the year. And though larger companies have strengthened their balance sheets, they are hesitant to deploy cash into investment expenditures. This essentially leaves the consumer as the last vestige for U.S. economic growth. But, considering that the average U.S. consumer is over-indebted in an environment of high unemployment and negative “real” (net of inflation) wage growth, one struggles to determine from where a sizable economic expansion will originate during the next six months. Since investors around the world still flock to the highly liquid U.S. Treasury market during global growth slowdowns, I do not expect a major Treasury bond selloff in the next few months. 3) The U.S. is still rated AAA by other rating agencies. Since Moody’s and Fitch did not downgrade the United States below AAA along with S&P on Friday, I do not expect a large amount of forced selling by institutions mandated to hold a certain percentage of their portfolios in AAA-rated assets. 4) Congress and the president may be spurred to forcefully address impending fiscal problems. Although I am not overly concerned about a sovereign debt crisis in the United States anytime soon, a crisis is inevitable should policymakers fail to address longer-term structural budget deficits. The inability to implement meaningful changes during the recent debt ceiling debate was certainly disappointing and no doubt led to S&P’s downgrade. I am hopeful that the downgrade will function as the catalyst that drives lawmakers to make long-term reforms to Medicare and Social Security before investors force the changes by inflicting pain in the bond and/or currency markets. If the United States can formulate an actionable plan to reign in longer-term entitlement spending, the Treasury bond market would take comfort.

Lederer PWM cannot guarantee any of the forecasts presented in this document.

5) Prior AAA sovereign downgrades have not led to major bond market selloffs. In April 2002, Japan was downgraded from AAA due to its ballooning sovereign debt levels, coupled with structurally weak economic growth. As the chart below shows, the country’s 10-year bond yields rose very briefly (and prices fell – bond yields and prices move inversely) following the downgrade but stayed on a downward path throughout the remainder of the year. Since the Japanese government bond market is large and the country’s economic data is highly transparent, the downgrade in 2002 really did not have much influence on sophisticated bond investors. Clearly, the country’s weak economy was a much greater factor. I would argue that this will prove to be the case with U.S. Treasury bonds as well during the next several months. Japanese 10-Year Government Bond Yields During 2002


Yields rose briefly after the downgrade prior to resuming a downward trajectory.


















Investment Strategy The recent downgrade has not changed my investment strategy whatsoever. I intend to maintain a defensive posture and will not likely consider becoming more aggressive unless the stock markets were to fall 8-10% from current levels.

Lederer PWM cannot guarantee any of the forecasts presented in this document.

















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