Sun, Aug 7, 2011
Today at about 4 pm, the Treasury’s John Bellows issued a hastily written statement, in which he explained why in his view, a day after a historic downgrade of its debt, the $ 2 trillion mistake that S&P made “raises fundamental questions about the credibility and integrity of S&P’s ratings action.” What is ironic is that in the explanation, it is the Treasury’s own credibility that is put at stake. Supposedly the reason for the mix up is as follows: “S&P incorrectly added that same $ 2.1 trillion in deficit reduction to an entirely different “baseline” where discretionary funding levels grow with nominal GDP over the next 10 years. Relative to this alternative “baseline,” the Budget Control Act will save more than $ 4 trillion over ten years – or over $ 2 trillion more than S&P calculated. (The baseline in which discretionary spending grows with nominal GDP is substantially higher because CBO assumes that nominal GDP grows by just under 5 percent a year on average, while inflation is around 2.5 percent a year on average.” So let’s get this straight: the Treasury department is kicking and screaming at S&P for daring to downgrade the US, when it is using as its baseline a forecast prepared by the same CBO which back in 2001 predicted a net negative debt balance by 2008 (!), and which in the same year expected 2011 US GDP to be $ 16.9 trillion, and a budget surplus of about $ 1 trillion, putting any S&P forecast from the peak of the credit bubble, to shame, but far more importantly, Bellows, and his plethora of bosses, is pissed that the S&P did not use a baseline that assumes a 5% GDP annual growth, when current annualized GDP, 2 years after the end of the recession, is under 2%? And this is what is supposed to make S&P less than credible? This is like the pot and the kettle having commenced global thermonuclear warfare.
As to what the end result of all this childish sniping most likely is, here is someone with far more credibility: Stone McCarthy. “Will the downgrade serve as a wake-up call to policymakers to step up their efforts on deficit reduction? We’re not hopeful based on the initial reactions we’ve seen. We haven’t seen any official press release from the White House or the Treasury, but most of the press quotes of Administration officials we’ve seen amount to sniping at Standard and Poor’s or efforts to undermine the rating agency’s credibility…We don’t think the implications of the downgrade for investors and markets are necessarily clear-cut and straightforward. Symbolically, the downgrade could be negative for U.S. financial markets, including the foreign exchange market, especially at a time when markets and the economy are fragile.” Translation: the market will promptly throw up at the rankly amateur response so far exhibited by the treasury which should be focusing on damage control such as exhibiting real deficit cutting measures instead of proving to the public what legendary excel goalseek experts it has on staff…
And speaking of Stone McCarathy, here is their complete outlook on why it may be a good idea to stay on the sidelines next week:
Will the downgrade serve as a wake-up call to policymakers to step up their efforts on deficit reduction?
We’re not hopeful based on the initial reactions we’ve seen. We haven’t seen any official press release from the White House or the Treasury, but most of the press quotes of Administration officials we’ve seen amount to sniping at Standard and Poor’s or efforts to undermine the rating agency’s credibility.
According to many news outlets, a Treasury official said “”A judgment flawed by a $ 2 trillion error speaks for itself,” referring to an error in S&P’s calculations. We’re not exactly sure what the error was, but it looks as though Standard and Poor’s assumed discretionary spending over some time frame that was $ 2.0 trillion more than a CBO baseline scenario. S&P’s conceded the error, saying that it changed its forecast that the debt-to-GDP ratio in 2021 would be 85% instead of 93%. And that wasn’t enough to prevent a downgrade.
Certainly, S&P’s and the other rating agencies have credibility issues following the meltdown in the private label MBS market. And a $ 2 trillion error doesn’t help S&P’s on the credibility front. But it’s hard to argue with S&P’s bottom line: The recent debt ceiling/deficit reduction deal didn’t go far enough, didn’t address revenues or tackle the huge fiscal challenge of entitlement spending. And based on the political wrangling we’ve observed over the past several months, there isn’t much reason to hope that the two parties can come together to tackle the big problems.
Following S&P’s announcement, House Speaker Boehner issued this fairly partisan statement:
“Republicans have listened to the voices of the American people and worked to bring the spending binge to a halt…Unfortunately, decades of reckless spending cannot be reversed immediately, especially when the Democrats who run Washington remain unwilling to make the tough choices required to put America on solid ground…It is my hope this wake-up call will convince Washington Democrats that they can no longer afford to tinker around the edges of our long-term debt problem.”
The statement from Senate Majority Leader Reid was a little less partisan.
“The action by S&P reaffirms the need for a balanced approach to deficit reduction that combines spending cuts with revenue-raising measures like closing taxpayer-funded giveaways to billionaires, oil companies and corporate jet owners. This makes the work of the joint committee all the more important, and shows why leaders should appoint members who will approach the committee’s work with an open mind – instead of hardliners who have already ruled out the balanced approach that the markets and rating agencies like S&P are demanding.”
Around August 16, Congressional leaders from both parties will have to name 12 members to the new joint committee charged by last week’s legislative deal to find $ 1.5 trillion in deficit reduction over the next 10 years. From what we’ve heard and read so far — contrary to Reid’s statement — leaders are looking to name hardliners to the committee. In other words, Republicans will name members who won’t budge on revenues and Democrats will name members who won’t give much ground on entitlements. Members of the Gang of Six need not apply. Whether the S&P action has much of an impact on the policy process going forward could become apparent when the members to the new joint committee are named.
The market implications of the downgrade are difficult to predict, and unfortunately our knowledge of the more practical consequences of a downgrade is pretty limited.
It probably makes some difference that the other two major ratings agencies have left their long-term U.S. sovereign rating unchanged for now.
Moody’s appeared to give policymakers a little more credit for what was agreed to in last week’s deal and also seems willing to give Washington more time to take further action. Moody’s issued this statement after the deal to lift the debt ceiling was reached:
“In confirming the Aaa rating, Moody’s also recognized that today’s agreement is a first step toward achieving the long-term fiscal consolidation needed to maintain the US government debt metrics within Aaa parameters over the long run…
“In assigning a negative outlook to the rating, Moody’s indicated, however, that there would be a risk of downgrade if (1) there is a weakening in fiscal discipline in the coming year; (2) further fiscal consolidation measures are not adopted in 2013; (3) the economic outlook deteriorates significantly; or (4) there is an appreciable rise in the US government’s funding costs over and above what is currently expected.”
Fitch Ratings, meanwhile, said policymakers need to go further than last week’s deal when it comes to deficit reduction, but seems to have more faith in the political process, certainly compared to Standard and Poor’s:
“The increase in the debt ceiling and agreement on the broad parameters of a deficit-reduction plan support Fitch’s judgment that, despite the intensity and theatre of political discourse in the United States, there is the political will and capacity to ultimately do the right thing. In Fitch’s opinion, the agreement is an important first step but not the end of the process towards putting in place a credible plan to reduce the budget deficit to a level that would secure the United States’ ‘AAA’ status over the medium-term.
“Nonetheless, at a time of heightened concerns regarding the creditworthiness of sovereign governments in mature industrialized economies, it is essential that a credible multi-year deficit reduction plan is articulated and implemented On current trends Fitch projects that U.S. government debt, including debt incurred by state and local governments as well as the federal government, will reach 100% of GDP by the end of 2012, and will continue to rise over the medium term – a profile that is not consistent with the United States retaining its ‘AAA’ sovereign rating.”
We don’t know to what extent investors may be required to sell Treasury securities based on a downgrade from one ratings agency, or how the downgrade might affect the status of Treasuries as collateral in things like repo transactions. We think that investor covenants related to credit ratings may be different for corporate bonds than they are for government debt. For bank capital purposes, for instance, our understanding is that the zero risk-weight attached to Treasuries isn’t based on a particular credit rating.
In sum, we don’t think the implications of the downgrade for investors and markets are necessarily clear-cut and straightforward. Symbolically, the downgrade could be negative for U.S. financial markets, including the foreign exchange market, especially at a time when markets and the economy are fragile. On the other hand, despite all of our problems, U.S. markets may still be regarded as a safe haven, given the problems in Europe.
Standard and Poor’s said it will issue separate releases on Monday regarding “affected ratings in the funds, government-related entities, financial institutions, insurance, public finance, and structured finance sectors.”
Among other things, we expect that S&P’s will be lowering the ratings for the GSEs and certain municipalities, whose AAA ratings have been a function of its relationship with the federal government.
Open of FX on Sunday should be once again quite amusing.
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