Christian Debt Recovery

Debt Buyers Conference

June 3rd, 2010 |

Author: Gavin

After the Downgrade, Patience and Pragmatism is a Must

S&P said they would and they did it. To no surprise, unimpressed with the final version of the U.S. deficit reduction plans, S&P delivered on its multiple warnings. Standard & Poor’s issued the historic downgrade of U.S. debt on August 5th, waiting until that Friday night to send a shockwave to global market participants. It reduced America’s long-term debt rating – which had been Triple A since 1941 – to AA+.1 The credit rating agency had threatened to lower the rating if Congress passed any deficit reduction plan smaller than $4 trillion in scope. The Budget Control Act of 2011 “falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics,” an S&P statement noted.

Further S&P continues to maintain its “negative” credit outlook on the U.S, and remains skeptical that the federal government can collect more money from taxpayers. Its analysts do not think the Bush-era tax cuts will sunset at the end of 2012 “because the majority of Republicans in Congress continue to resist any measure that would raise revenues.”2

On August 5th, S&P sovereign ratings committee chair John Chambers told Fox News that the new AA+ rating could be cut to AA within 6-24 months if the U.S. doesn’t arrange to slash at least $4 trillion from its deficit in the next decade.3 The implication is should Congress not agree on more deficit reductions by February 2012, additional downgrading could commence.

Markets React As Expected. When U.S. markets opened on Wall Street Monday August 8th, they promptly took a dramatic plunge with the Dow Jones Index falling 634.76 points, the S&P500 falling 79.92 points, and the NASDAQ dropping 174.42 points. It was the worst day on Wall Street since December 1, 2008, when the National Bureau of Economic Research announced America had lapsed into a recession.4

Investors across the globe endured a roller coaster ride as the market swung in huge moves up and down from day to day throughout the week. Last spring 2010, the S&P 500 pulled back 16% from a prior peak only to eventually move higher for the year. As the Dow Jones Index finished 2010 up 11.0%, the S&P500 was up 12.8% and the NASDAQ wound up 16.9% higher.

The Treasury Fights back. Late Friday evening, after spending many hours conferencing with S&P, as well as internally, the Treasury Department came out swinging. It argued that S&P’s analysis contained an accounting error that unnecessarily added $2 trillion to its projection of U.S. debt. S&P promptly admitted the error…and stuck with the downgrade.1

Even President Obama in a national news conference on Monday, challenged S&P’s downgrade. While nobody’s running away from U.S. Treasuries yet, in fact as in prior global market crises, buyers rushed to buy them, Treasury yields sank 0.18% August 8th. This made it momentarily cheaper for the U.S. to finance its debt.

What is China saying…? The United States’ prime lender (by virtue of being the world’s largest holder of U.S. debt) gave a very harsh assessment of Congress, through its official news agency, Xinhua. The Chinese commentary stressed that the U.S. has a “debt addiction” only curable via major cuts to defense spending and entitlement programs. It also said that the option of a “new, stable and secured global reserve currency” should be explored.5

These comments echo similar statements that have emanated from Beijing over the past year in an increasing volume. In fact as an example, I quote from Stephen S. Roach, Non-Executive Chairman of Morgan Stanley Asia, who is currently serving on the faculty at Yale. Amongst many profound statements in his recent writing titled Read China’s Lips, he states the following:

“…China has adopted a very transparent response. Its new 12th Five-Year Plan says it all – a pro-consumption shift in China’s economic structure that addresses head-on China’s unsustainable imbalances. By focusing on job creation in services, massive urbanization, and the broadening of its social safety net, there will be a big boost to labor income and consumer purchasing power. As a result, the consumption share of the Chinese economy could increase by at least five percentage points of GDP by 2015. So China, the largest foreign buyer of US government paper, will soon say, “enough.” Yet another vacuous budget deal, in conjunction with weaker-than-expected growth for the US economy for years to come, spells a protracted period of outsize government deficits. That raises the biggest question of all: lacking in Chinese demand for Treasuries, how will a savings-strapped US economy fund itself without suffering a sharp decline in the dollar and/or a major increase in real long-term interest rates?” 6

For those still digesting and/or in disbelief of what this means; the Chinese are very clearly saying that they will seek to wean themselves of using U.S. dollars as their sole reserve currency by exploring other options. And more bluntly like the U.S. did in the 40′s-70′s, they will urbanize their country, increase income of their citizens, thus increasing internal (domestic) consumption which will decrease the need for our dollars! This common sense form of nationalism by the world’s largest lender is being accelerated by the behavior of its largest debtor, at the worst potential time for the debtor (U.S.).

Will the U.S. be Triple A again? It might take years for that to happen via S&P, which has cited political gridlock on Capitol Hill as a major reason for the downgrade, and it doesn’t see that going away in upcoming months. On top of that, the U.S. economy expanded just 1.3% in the first half of 2011 – about half the pace needed to dispel the lingering effects of recession.7

However, Moody’s Investor Services affirms America’s Triple A rating as its senior credit officer Steven Hess wrote in an August 8th note, “Despite the outlook for some further deterioration in the government’s debt metrics over the coming few years, we believe that the U.S. continues to exhibit the characteristics compatible with a Triple A rating.” Moody’s also noted America’s longstanding track record of economic growth as a big reason for confidence.

Additionally, Fitch Ratings also refrained from a U.S. credit downgrade, and both Moody’s and Fitch stated that the possibility of sovereign default was remote.8 As a historical example, S&P downgraded Canada’s Triple A credit rating in the spring of 1993, and our Canadian neighbors got their Triple A rating back by 1997. (FYI- they currently have a debt-to-GDP of 35% compared to 90%+ for U.S.)

What Now? JPMorgan Chase analysts think Treasury yields could increase by 60-70 basis points as a result of the downgrade, translating to $100 billion in added annual borrowing costs for America. Citing Federal Reserve research, these analysts think that an increase of 50 basis points in Treasury yields (0.5%) could take a 0.4% bite out of U.S. GDP.2 Some think the consequences of the downgrade will be that mortgage rates and credit card rates will begin to rise in the near future, while many others say they will not rise due to a slowing economy and related lack of demand. Rates on conventional mortgages have a direct relationship with 10-year Treasury yields. Recently, those yields have dramatically fallen, and demand for longer-term Treasury notes has been palpable. Interest rates on auto loans might see a spike, as those rates are pegged to 2-year notes and factors like the LIBOR rate. The hardest hit might come from credit card issuers. Credit card interest rates reflect the prime rate. Credit.com credit card advisor Beverly Blair Harzog told CNN Money that she believed credit card firms could possibly jack up rates 1-5% as a result of jitters over the downgrade.9

Though this level of turmoil can prompt you to make major moves as a response, remember that impulsive decisions are often regretted down the line. We will all have to wait and see how this plays out over the next several months. Thus decisions made today should be rooted in responding to the current situation with a clear eye on where you are headed tomorrow. Remember chaos brings opportunity!

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About the Author

Financial Management Strategies, LLC (FMS) is a Registered Investment Advisory firm in the State of Maryland, providing its advisory services to both institutions and individuals.

Mr. Petiri is the owner of Financial Management Strategies, LLC (FMS) a Registered Investment Advisor established in the year 2000. His nearly two decades of financial experience covers virtually all areas of finance from tax, insurance, stockbroker, personal financial planning and personal banking to corporate credit, business planning and consumer lending.

Mr. Petiri has frequently been heard on WEAA (88.9 FM) as a financial commentator, appeared on WMAR-TV 2 regarding the 2008 & 2009 economic downturn, and MTA Commuter Connections (local public access cable channel) regarding residential land development. He has been interviewed and quoted by the Investment News magazine, written for the Journal of Personal Finance, is a frequent contributor to the IARFC publication, The Register, Popular Finance (of China), and publishes a monthly financial advice column called the Foresight. Mr. Petiri was also recently quoted in Bankrate.com and currently writes for the Baltimore Examiner. He serves on the Finance Committee of Associated Black Charities. Walid is a devoted parent to his son and daughter and a member of Bethel African Methodist Episcopal Church.