S&P downgrading of the US credit outlook: A discussion with Peter Cohan and David Caploe

It was a shock in the afternoon in Europe. Standard & Poor’s (S&P) today (April 18) downgraded its credit outlook for the United States, the outlook turned negative from stable. While the credit rating agency maintained the country’s iconic triple A (AAA, the top) credit rating, the move signals that S&P could cut its long-term rating on the United States within a horizon of two years. Reality check came to America.

This “menace” was what the financial markets didn’t want to imagine, even listen. The attentions were immediately diverted away form the severe problem with Greece – the high probability of a restructuring of its sovereign debt in a 12 month horizon – and the score of True Finns populist party in Sunday Finnish elections.

The move to negative outlook in the triple A rated superpower from S&P triggered a mini-crash in the Wall Street (Dow Jones lost more than 1%) and at the Nasdaq in Times Square (lost 1%). The costs of the credit default swaps (CDS) for the US sovereign bonds went up 19%, according to CMA DataVision. It was the champion today of the sovereign wideners. Gold topped to a new historical high of $1492.9 an ounce. In a month gold price gained $100. But yields in the secondary market for US Treasury bonds with maturities of 5, 10 and 30 years paradoxically went down. Contradictory signals confusing the analysis.

The reason for that move from S&P probably was a political one. The rating agency cited the country’s “very large budget deficit and rising government indebtedness” and the “reasonable chance that it would still take a number of years before the government reaches a fiscal position that stabilises its debt burden”.

The timing was very appropriate indeed: its decision comes at a very sensitive moment in US politics, with the Obama Administration trying to reach an agreement with Congress on a medium term fiscal consolidation plan. Obama’s opponents in the House will no doubt use S&P’s downgrading as warfare in their negotiations.

Ironically, S&P statement sorted out just the day after US Treasury Secretary Timothy Geithner at the IMF meeting in Washington talked – in an optimist mood – about the ongoing discussion for an agreement in the Congress on a multi-year roadmap to cut $4 trillion on the US budget. Reaching agreement will be difficult, but the alternative – default – is unacceptable. But there is a risk in all this game if hard politics takes control. The debate can fuel uncertainty and loss of faith among investors that the US will in the end manage its long-term fiscal pressures.

We interviewed two American analysts – one in Boston and another in Asia, in Singapore. Peter Cohan, from Peter Cohan & Associates in Boston, and David Caploe, chief-economist of Economy Watch in Singapore, were our guests tonight. Two visions – with clear differences.

Edited by Jorge Nascimento Rodrigues @2011

Q: Is this the first signal regarding countries with triple AAA rating, but with big problems in the shadow?

PETER COHAN: Yes – I think that the ratings agencies will have no problem downgrading countries with problems. The U.S. Federal budget deficit is expected to be about 11% of GDP and our national debt is 100% of GDP. Countries with those kinds of numbers are going to get negative views from the ratings agencies. Of course, nothing in the S&P report is news to investors. Both sides are talking about ways to reduce the U.S. federal deficit by $4 trillion in the next decade and S&P’s report expresses skepticism that a solution can be reached. But this issue has been around for at least two years since the financial crisis started. Meanwhile, the U.S. 10-year treasury bond yield fell from 3.51% last Friday to 3.37% which is lower than Germany’s 3.6% so it looks like the S&P announcement is not spooking investors. In fact, it seems to be having the opposite effect – it is making them more confident about solving the debt problem.

DAVID CAPLOE: Honestly, it’s really hard to tell what this means. S&P has been foreshadowing this, so it’s not really a huge surprise. But it is a shock. In general, I tend to take the view that it’s a comment on the ongoing deterioration of governance in the US in general, and Washington in particular. The main concern in the announcement is the seemingly unbridgeable gap between Democrats and Republicans on practically every major economic issue, including the passing of the debt limit. The problem is that an ambiguous move like that only gives fuel to each side, so rather than improving what they claim to see as a problematic situation, I think it’s only going to make it worse.

Q: The move from S&P is basically helping political movements in the Congress and Senate?

PETER COHAN: Yes—the announcement helps put pressure on both sides to solve the deficit and debt problem. The drop in the 10 year yield is a signal, as I noted above that investors expect the risk of a U.S. ratings downgrade to boost the odds that a solution will be reached.

DAVID CAPLOE: As I said, I actually think it’s going to make things worse. It’s going to convince each side that it’s the fault of the other side that things are so bad. In this case, there’s no question in my view the Republicans are operating from a fundamentally extreme right-wing position that either can’t or refuses to see any sort of larger picture. As long as they continue with their myopia regarding taxes, the stalemate seems likely to continue since, despite their pathetic weakness, the Democrats — who seem in their final throes of a descent into irreversible irrelevance — can’t give up on their minimal baseline without losing any credibility with their base for 2012. So even if the idea is to put pressure on Congress, I don’t think it’s going to work — especially since the AAA rating has been retained, at least for now.

Q: Which outcomes we can expect from Chinese, Japanese investors in US sovereign?

PETER COHAN: The market’s reaction suggests that Chinese and Japanese investors are going to see U.S. government securities as more attractive because the fear of a downgrade will boost the odds of stronger U.S. financial condition. Thus, the U.S.’s role as a safe haven will be reinforced.

DAVID CAPLOE: Well, that’s always an open question, but I don’t think either the Chinese or Japanese are going to stampede out of US bonds, albeit for different reasons. As you know, the yen shot up right after the tsunami, on anticipation of massive yen repatriation for re-building. But as soon as there was an intervention, the yen fell back again, which I think says the Japanese realize they are in for a long haul, and will need the goodwill of the US to have a prayer of getting back on their feet. Therefore, I don’t think they are going to want to alienate Americans over a few basis points, especially given their own weakness, both since 1989 and most recently. The Chinese also tend to be very patient in their dealings with external sovereign debt, so I don’t think they’re going to be stampeding either. The US pessimists argue they will soon use their dollar liquidity to purchase American assets, which may or may not happen. But the Chinese know they benefit greatly from the structural dynamics of the current world political economy, in some ways more than any other country, so I don’t think they’re going to do anything to jeopardize the current system.

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