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2012, May 23

New World Order: Asia and the US Downgrade

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New World Order: Asia and the US Downgrade

by Royal Bank of Scotland, 12 August 2011
topics:
Risk Management
tags:
risk-free rate us credit rating downgrade US debt ceiling US Treasuries
  • We believe the flight to safety argument in favour of US Treasuries is bogus. The whole point is that what used to be safe can no longer be considered so. Reserve managers know this and have been avoiding the stuff for months.

 

  • It seems logical, and likely, that at some point yields will rise reflecting the obvious deteriorating creditworthiness of the US. Meanwhile, we expect risk aversion to make the dollar rally against developed markets peers, in contrast to consensus belief.

 

  • In a new world without any one exclusive risk-free rate, the discount rate applied to well-funded capital self-sufficient economies will fall. After the initial volatility- and liquidity-related moves, that is what we expect to see happen. Asia looks well positioned in this sense due to its fundamental strengths of lower debt, external surpluses and higher growth.
 
When ‘Risk-Free’ Becomes Risky
It’s finally official: the US is no longer the safest credit around according to the good people at ‘moody and poor’. But while Europeans might agree that it was about time, their glee will not last as countries such as France, Austria and the UK look set to follow. (Editor's Note: S&P affirmed France's triple-A rating on August 11.)
 
Beneath the obvious inability of politicians and bureaucrats to deal with the fundamental issues lie a more sinister reality and a potential outcome not comfortably spoken about, at least in public. The downgrade of US debt from the AAA rating to AA+ is not shocking or disturbing in itself. After all, who in their right mind has trusted the rating agencies for the past decade (they have been backward looking for at least that long)?
 
The real issue is what the global financial system will look like when the de-facto risk-free assets turn risky.
 
The fact that investors globally have preferred to take shelter in low (no?) yielding US Treasuries at the very time where the risks of those instruments have been rising for a long time can only be described as ironic and insensible.
 
So, maybe reserve managers won’t sell Treasuries, but presumably they won’t buy them either (this has been the trend for some time now). Given the size of outstanding stock that sooner or later matures (and needs rolling) and given the size of the US fiscal deficit which needs funding . . . Well, supply isn’t exactly limited.
 
Have a think about what endless supply and a sense of credit risk have done to Greek, Irish, Portuguese, Spanish, Italian and now even the French (sacre bleu!) bond yields. Related to this, S&P, to appear consistent, will also have to downgrade other AAAs – starting with, perhaps, France. (Imagine the impact on the euro, which we see as clearly fundamentally overvalued).
 
It is true that the US retains the ability to print money and move its currency, so that does provide an alternative outlet. Still, we see Treasuries as having poor fundamentals (especially for non-US dollar based investors) and badly overpriced, at a time when someone official has just let it be known that the emperor – as we all suspected – is in fact naked.
 

Demise of the Dollar

It is simply scary how strong the consensus is that Treasuries will stay strong forever – very akin to the consensus surrounding tech stocks in late 1999. Ultimately what is passing before our eyes are several major events.
 
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