U.S. bond rating alarm sends investors fleeing ... to U.S. bonds

ECONOMIC TURMOIL

U.S. bond rating alarm sends investors fleeing ... to U.S. bonds

DAVID BERMAN | Columnist profile

From Tuesday's Globe and Mail

Published Monday, Aug. 08, 2011 6:15PM EDT

Last updated Monday, Aug. 08, 2011 7:07PM EDT

For all the anxiety that Standard & Poor’s unleashed when it downgraded the U.S. credit rating on Friday, markets reacted with barely a shrug on Monday.

Make no mistake: Stocks were pounded in another rout, pushing major indexes deeper into correction territory. The S&P 500 fell 6.7 per cent, bringing its total decline since April to 17.9 per cent.

These represent alarming losses for investors, and many observers are scratching their heads over what will bring back some sense of stability to stock markets after a particularly volatile couple of weeks.

However, blaming the setback on the Standard & Poor’s downgrade doesn’t appear to make much sense at this point.

The clearest evidence: Even though Standard & Poor’s declared that U.S. bonds no longer deserved a top-notch triple-A credit rating, investors embraced those bonds enthusiastically.

U.S. government bonds surged on Monday, sending yields down. The yield on the 10-year U.S. Treasury bond slipped below 2.4 per cent for the first time since October and challenged lows last seen during the financial crisis.

“This amounts to a massive market rejection of S&P’s concerns,” Paul Krugman, the Princeton University professor and New York Times columnist, said on his blog. “The ‘signature’ of debt concerns should be stock and bond prices both falling; what we actually see is those prices moving in opposite directions.”

It is also hard for a downgrade of U.S. debt to gain much traction when big investors, including central banks, have few other places to go. The Swiss franc and gold markets just aren’t big enough to satisfy demand.

David Rosenberg, chief economist and strategist at Gluskin Sheff, argued that for all intents and purposes, the world will continue to treat the U.S. credit rating as top notch, in spite of the downgrade.

“The U.S. can print its own money and certainly has the wherewithal to pay its debts, so the downgrade is more symbolic than real,” he said in a note.

So why are stock markets in such a stink? Rising bonds and falling stock prices usually mean just one thing: Investors are growing very nervous about the health of the global economy – and more specifically a bout of disappointing economic data and the next phase of the European debt crisis, which has been showing clear signs of spilling into Italy and Spain.

Mr. Rosenberg, who was never convinced about the lasting power of the global economic recovery, believes this downturn is more serious than the scare that sent stocks reeling last summer when Greece, Portugal and Ireland were the focus of concern.

The European debt crisis now involves bigger economies, such as Spain and Italy, and has raised concerns about the health of the continent’s bigger banks. Looking more widely, Mr. Rosenberg points to signs of global economic decline, including the slide in German industrial production in June, the dimming outlook for Australian economic growth and shrinking U.S. consumer spending for three successive months.

“The global economy is slowing down much faster than was the case then [in 2010] and the problems surrounding sovereign government debt are far more acute,” he said.

But at least one aspect is the same: As investors scramble for cover from the volatility, they are turning to the same havens. Standard & Poor’s might be taking a dimmer view of U.S. government bonds, but everyone else can’t get enough of them.

S&P cuts ratings tied to U.S. sovereign credit

S&P cuts ratings tied to U.S. sovereign credit

JOAN GRALLA

New York— Reuters

Published Monday, Aug. 08, 2011 2:20PM EDT

Last updated Monday, Aug. 08, 2011 2:24PM EDT

S&P based its decision on grounds the U.S. Congress and President Barack Obama have not done enough to compress the budget deficit and rising debt burden.

Morgan Stanley on Monday warned: “Because of the unprecedented nature of negative credit rating actions with respect to U.S. government obligations, the ultimate impacts on global markets and our business, financial condition and liquidity are unpredictable and may not be immediately apparent.”

Even Berkshire Hathaway Inc.,(BRK.A-N101,000.00-6,300.00-5.87%) the heavyweight insurer run by billionaire investor Warren Buffett was swept up in the wholesale credit revisions, with S&P affirming its double-A-plus rating but cutting the company’s outlook to “negative.”

Four of Berkshire’s peers suffered the same fate: Assured Guaranty, Guardian, Massachusetts Mutual, and Western & Southern. Five U.S. insurance groups were cut by one notch to doulbe-A-plus: Knights of Columbus, New York Life, Northwestern Mutual, Teachers Insurance & Annuity Association of America and United Services Automobile Association.

The ratings of four institutions that clear and process trades and are crucial to the daily workings of the U.S. financial markets were cut to double-A-plus from triple-A.

These institutions, which work behind the scenes but play a vital role, are: the Depository Trust Co., National Securities Clearing Corp., Fixed Income Clearing Corp. and the Options Clearing Corp.

Wayne Luthringshausen, chairman of the OCC, said: “This rating change will have no impact on OCC’s operations or our ability to meet our obligations to OCC’s clearing members.”

S&P – the only ratings agency to cut the U.S. rating from the highest rank – said the downgrade constrains the depository and clearing houses because “their respective businesses and the assets they hold are concentrated in the domestic market.”

“We have not changed our view of the fundamental soundness of their depository or clearing operations,” it said.

Giving the four depository and clearing institutions negative outlooks, S&P also cited the long-term stability of U.S. capital markets.

Credit ratings for some of the main arteries of the U.S. financial system – from clearing houses to government mortgage agencies – were cut one notch to double-A-plus by Standard & Poor’s Ratings Services Monday.

S&P in a statement said the downgrades – which also hit big insurers – were due to its lowering of the U.S. sovereign credit rating late on Friday. That decision is prompting the agency to review ratings of a host of entities whose financial health depends heavily on the federal government.

The U.S. municipal market began getting more guidance as S&P cut to double-A-plus the ratings of some defeased industrial revenue bonds. The credit agency now rates 13 states at triple-A and it is reviewing the impact of the country’s debt consolidation plan on the budgets of states and municipalities, said David Beers, who leads the agency’s sovereign ratings group.

In early afternoon trade, muni bond yields were unchanged to three basis points lower. This follows last week’s stunning rally when the yields of some top quality tax-free bonds fell as much as 40 basis points.

As expected, S&P cut by one notch to double-A-plus the ratings of Fannie Mae and Freddie Mac, the two government-sponsored enterprises that are central to the U.S. residential mortgage market. A Freddie Mac spokesman, Doug Duvall, had no immediate comment. A Fannie Mae spokesman was not immediately available.

The Federal Home Loan Banks were also cut to double-A-plus.

For Canada, crisis in the U.S. and Europe presents an opportunity

“This is an opportunity for Canada,” says former Prime Minister Paul Martin, who was finance minister in Jean Chrétien’s government during the 1990s when the Liberals tackled this country’s own fiscal mess.

The tough path that Mr. Chretien and Mr. Martin embarked on in 1994 ultimately restored Canada’s AAA rating, which had been downgraded to AA+. Now it’s the turn of the United States. And as Europe continues to flounder under the weight of its issues, the need for it to undergo serious political reform is becoming more obvious by the day.

Canada too has a deficit that it should grapple with, and it must continue to bring down its debt-to-GDP ratio, Mr. Martin said. But it is not in need of the severe medicine that other economies must now take, medicine that will have long-lasting side effects and allow Canada to become even more of a positive outlier.

Mr. Martin would like to see Canadian governments use this time to make investments in infrastructure and education systems that will further distinguish the country. “We should be able to attract the best and brightest into our industries better than we ever have before, simply because of what’s going on in other countries,” he said in an interview Sunday.

The chance to capitalize on this situation might last for some time, as the full extent of the necessary reforms in Europe and the United States is still becoming evident, and those countries’ political leaders are still mustering the will to act.

“What is giving a lot of people pause is not only the dysfunctionality of the United States – of Congress and its relationship with the administration – but the dysfunctionality between the European Central Bank, the European Commission and a number of the European countries beginning with Germany,” Mr. Martin said.

“The Europeans should deal with their issues,” he added. “I think what you’re beginning to see in Europe is increasing pressure for a pan-European bond. You can’t be half pregnant. Europeans have got to face up to the need for far greater economic integration, if in fact they are going to deal with these issues. They can’t think that they can go halfway.”

For Canada, crisis in the U.S. and Europe presents an opportunity

TARA PERKINS

From Monday's Globe and Mail

Published Sunday, Aug. 07, 2011 10:47PM EDT

Last updated Sunday, Aug. 07, 2011 10:51PM EDT

With much of the developed world in fiscal crisis, this could be Canada’s moment.

While the deepening economic pain in the United States and Europe will inevitably touch this country, Canada’s relative financial health will continue to rise as new tax measures and cutbacks engulf other nations.

In the meantime, the United States is clearly going to have to raise revenue through taxes and rethink its entitlement programs. The administration still has time to prevent the economic nosedive that some pessimists are now forecasting, Mr. Martin suggested. But it must get down to work.

The debt ceiling issue was simply a manufactured problem. “The U.S. problem is its large annual deficits and its steadily increasing debt-to-GDP issue,” Mr. Martin said. “What they’ve got to do is bring forth a plan that is going to turn that debt-to-GDP ratio around.”

The S&P downgrade of the United States’ formerly stellar AAA rating did not tell market participants anything that they didn’t already know. What is really having an impact on investors’ psyches right now is “the last sputtering of hope that either Europe or the United States was going to deal with their issues,” Mr. Martin said.

“If a rating agency’s downgrading can get political forces to deal with these issues, that would be a good thing.”

Why this debt crisis is different

GLOBAL DEBT STORM

Why this debt crisis is different

GRANT ROBERTSON AND BRIAN MILNER

From Monday's Globe and Mail

Published Sunday, Aug. 07, 2011 7:55PM EDT

Last updated Monday, Aug. 08, 2011 12:16PM EDT

This recovery is unfolding like no other in recent memory.

Government debt has brought the world to the edge of a brand new financial crisis, in a stark reminder that the biggest economies of the world are only three years past a major financial system failure. The financial crisis and ensuing recession saddled many governments with an unprecedented level of debt, as they spend money to fix insolvent banks, soften the blow for millions of unemployed and try to stimulate growth.

Other debt crises over the past three decades have typically involved smaller countries, including Canada in the early-to-mid-1990s, that were able to lean on the larger economies of the world to drive growth while they took steps to clean up their own books.

But unlike earlier predicaments, this one is not borne of a normal, cyclical recession, where the economy expands and then contracts when supply exceeds demand and business inventories get too high.

Rather, the U.S. and Europe – still by far the world’s two most important economic blocs – are mired in a so-called balance-sheet recession, where the combination of too much debt and too little confidence suppresses demand for a long period of time. These kinds of recessions are much harder to pull out of, as Japan has discovered since its real-estate crash two decades ago.

That has left policy makers in the United States and Europe trying to dig themselves out of debt while stimulating their economies with a dearth of tools.

Now, investors are waking up to just how intractable this type of economic crisis can be.

“The pity of it is that there’s no easy fix,” said Robert Kessler of Kessler & Associates. “They could say everyone will have to tighten their belts and change their lifestyle; and once [public] debts are paid down, you’re going to have a better country. Okay, so call me in 10 years.”

The description of the balance-sheet recession was popularized by influential Japanese economist Richard Koo when Japan ran into a similar situation. Corporations and consumers follow a credit binge by focusing on reducing their debt, which can take a decade or more to work out.

Banks sit on their money, borrowing dries up and demand shrinks, leaving public-sector spending as the only alternative. In Japan, heavy deficit-spending in the 1990s prevented a full-blown depression that could have seen the Japanese economy shrink by as much as 50 per cent. But Mr. Koo has argued the government made a critical error by attacking its deficit in 1997 and again in 2001, prolonging the slump.

The whole concept of a credit recession is deleveraging. When governments withdraw stimulus, as is now occurring in the U.S., Europe and elsewhere, it makes the problem worse, as Mr. Koo notes. Coming out of an ordinary recession, consumer spending picks up, as does corporate investment. Production expands to meet growing or prospective increases in demand and job growth occurs. Governments can withdraw stimulus in the knowledge that business will take over the reins of economic expansion.

But in a balance-sheet or credit recession, businesses continue to retrench, even when capital is plentiful and cheap.

Canadian investor Stephen Jarislowsky has described a balance-sheet recession as fundamentally different than a cyclical recession. “A balance-sheet recession is where you have a big bubble, and everybody and his brother has to de-lever in order to become really solvent again. By that, I mean they have to get debt off their balance sheet.

“The more everybody [reduces debt], the deeper the recession becomes, unless it’s counteracted by fiscal spending.”

When Canada and Sweden faced significant debt worries in the early 1990s, both countries were able to count on the growing world economy – fuelled by U.S. expansion and a rapidly growing technology sector – to give themselves momentum. In Canada’s case, deep spending cuts undertaken by Ottawa, along with the introduction of the Goods and Services Tax in 1991, helped pay down debt and return the government to surplus much faster than had been anticipated.

“Canada was definitely better positioned to deal with its deficit situation in the ’90s, [for] three reasons: We did have a strong U.S. growth performance to lean on, our deficit was significantly smaller as a share of GDP, and much of the deficit was due to outsized interest costs,” said Douglas Porter, deputy chief economist at the Bank of Montreal.

“There’s next to no room for that now in the U.S. – it will require very real restraint for and extended period of time. Given the political climate, not to mention the high starting point for U.S. unemployment, that looks like a very tall order indeed.”

U.S. GDP revision likely to lift loonie

ECONOMY LAB

U.S. GDP revision likely to lift loonie

STEPHEN GORDON

Globe and Mail Blog

Posted on Tuesday, August 2, 2011 6:40AM EDT

Stephen Gordon is a professor of economics at Laval University in Quebec City and a fellow of the Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE). He also maintains the economics blogWorthwhile Canadian Initiative and can be followed on Twitter.

The U.S. Bureau of Economic Analysis released its advance estimate for GDP growth on Friday, and the news was bad in several different ways. Growth in the second quarter was only 1.3 per cent, which is not a number consistent with a narrative of a strong U.S. economic recovery. Worse, the estimate for growth in the first quarter was revised from 1.8 per cent down to 0.4 per cent.

But the most disconcerting aspect of the new data release was the sharp downward revision for the entire path of GDP since 2007; see the accompanying graph.

Before Friday’s revisions, it was believed that the peak-to-trough reduction in U.S. GDP had been 4.1 per cent and that this loss had been recovered by the fourth quarter of 2010. In contrast, the most recent data tell a story in which output fell by 5 per cent, and in which this loss had still not been recovered as of the second quarter of 2011.

What does this mean? For one thing, the odds of a third round of quantitative easing on the part of the U.S. Federal Reserve have increased. A more expansionary fiscal policy is almost unthinkable given the political realities of the current Congress, so the monetary expansion is the only tool available to deal with a labour market that has still yet to show signs of recovery.

What this means for Canada is less clear. Although GDP growth rates in the two countries are highly correlated, this doesn’t necessarily mean that data revisions are similarly correlated. Statistics Canada has already revised down its preliminary estimates for 2009 GDP (see here), and its latest round of major revisions were published in May.

If Canadian numbers are not revised down, then this bad U.S. news will change little for policy-makers in Ottawa -- except for the increased likelihood of a continued appreciation of the Canadian dollar.

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U.S. Debt

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