S&P Downgrade Proves Absurd as Investors Prefer U.S. Assets
Four months after Standard & Poor’s stripped the U.S. of its AAA credit rating and said the world’s biggest economy was no longer the safest of borrowers, dollar- denominated financial assets are doing nothing but appreciating.
Government bonds have returned 4.4 percent, the dollar has gained 8.6 percent relative to a basket of currencies, and the S&P 500 Index of stocks has rallied 1.7 percent since the U.S. was cut to AA+ from AAA on Aug. 5. The cost for the nation to borrow has fallen to record lows since S&P said the U.S. was no longer risk-free, with the average monthly yield in November on 10-year notes below 2 percent for the first time since 1950.
Demand for American assets is increasing as consumer confidence, manufacturing and employment show the U.S. is strengthening as Europe struggles to save its currency union and the developed world weakens. U.S. gross domestic product will expand 2.19 percent next year, compared with 1.55 percent for the Group of 10 nations, Bloomberg surveys of economists show.
“The U.S. is our favorite market,” Hiromasa Nakamura, a bond investor in Tokyo at Mizuho Asset Management Co., which oversees the equivalent of about $42 billion, said Dec. 12 in a telephone interview. “The level of debt is high but I think they will deal with it,” he said. “Financial dislocations are continuing and investor money is flowing to the reserve currency, the U.S. dollar.”
When it lowered the U.S. rating, S&P, the world’s largest provider of credit analysis, said the failure up to then of Democrats and Republicans to agree on budget cuts made the U.S. less creditworthy, downplaying the country’s ability -- unlike individual European nations -- to print as much money as it needs to pay its debts. Congress cleared a $1 trillion spending bill on Dec. 17 that lawmakers called a bipartisan compromise.
“It is the ability to print one’s own currency to pay government bond investors back under any circumstances that makes a government bond a government bond, i.e. a (credit) risk- free asset for hold-to-maturity investors,” Elga Bartsch, the chief European economist at Morgan Stanley in London, said in a report this month to clients.
Long-term Treasuries are the best performing government bonds in the world this year, returning 30 percent, according to Bloomberg/EFFAS indexes. The S&P 500 has gained since August even as the MSCI All Country World Index fell 5.7 percent.
IntercontinentalExchange Inc.’s U.S. Dollar Index, which measures the greenback against the euro, yen and four other major trading partners, rose 2 percent last week and was at 80.282 at 12:34 a.m. New York time, from 74.598 on Aug. 5.
Investors are showing no reluctance to lend to the U.S., bidding a record $3.02 for each dollar of the $1.96 trillion of Treasury notes and bonds sold this year, according to data compiled by Bloomberg. That’s up from $2.56 in 2007 when the U.S. issued $581 billion in notes and bonds, government data show.
“Treasuries are clearly the safest asset in the world, they will continue to be the safest asset in the world,” James Staley, chief executive officer of JPMorgan Chase & Co.’s investment-banking unit, said today on Bloomberg Television’s “InsideTrack” with Erik Schatzker. “A downgrade in and of itself doesn’t really change the equation.”
Yields on 10-year Treasuries rose 2 basis points today to 1.83 percent, down from 2.56 percent on Aug. 5. Yields slid 21 basis points last week, or 0.21 percentage point, in the biggest drop since the five days ended Nov. 4, Bloomberg Bond Trader prices show.
Foreigners increased holdings of Treasuries by $17.2 billion in August, September and October to $4.66 trillion, the latest government data show. Non-U.S. buyers own about 48 percent of U.S. marketable debt, up from 34 percent when the nation had a budget surplus in December 2000.
“The fact that the U.S.’s credit rating was cut from AAA is not relevant,” said Jack Kelly, a fund manager at Standard Life Investments in Edinburgh, which oversees the equivalent of about $200 billion. “Treasuries are benefiting from an enormous flight to quality.”
History shows that a rally following a sovereign downgrade isn’t unusual.
After S&P cut Japan in February 2001 to AA+ from AAA, 10- year bonds yields fell below 1.15 percent four months later from 1.46 percent. Yields were at 0.97 percent today, even though S&P ultimately reduced the nation to AA-. Moody’s Investors Service waited until May 2009 to lower Japan’s foreign currency rating from Aaa, and now has it at Aa3, the same as S&P.
The yen appreciated as much as 2 percent by the end of June 2001, and is 4.7 percent stronger in 2011, based on Bloomberg Correlation-Weighted Indexes that measure the currency against a basket of nine developed-nation peers. While the Nikkei 225 Stock Average was little changed four months later, it had surged as much as 11 percent by May 7, 2001.
As the U.S. strengthens, the outlook for other parts of the world is deteriorating. Economists raised their forecasts for growth in U.S. gross domestic product next year to an average of 2.2 percent from 2 percent in October as they trimmed their estimate of Europe by 0.5 percentage point to 1 percent according to separate surveys by Bloomberg.
Demand from international investors is good news for President Barack Obama because the Treasury was able to fund the third-straight budget deficit of more than $1 trillion at a lower cost as a percentage of GDP than when the nation posted surpluses from 1998 to 2001. Interest expense accounted for 3 percent of the economy in fiscal 2011 ended Sept. 30, down from 4 percent in 1999.
U.S. economic indicators have improved since S&P’s downgrade, with consumer confidence, as measured by the Thomson Reuters/University of Michigan preliminary index, rising to a six-month high in December.
Inflation was little changed in November and manufacturing expanded at the fastest pace in five months, according to the Institute for Supply Management’s factory index. Private employment rose 206,000 last month, the strongest increase this year, ADP Employer Services said.
The U.S. received its highest rating from international investors in more than two years, with 41 percent saying in a Bloomberg poll conducted Dec. 5-6 that the country would be among top performers in 2012.
Not everyone agrees the U.S. is more creditworthy. Sixty- seven percent of 1,031 global investors in a Bloomberg Global Poll in September said S&P’s move was justified.
Moody’s, the second-largest ratings company, put its top Aaa grade for the U.S. on “negative outlook” during the budget debate. Fitch Ratings said last month there was a greater than 50 percent chance it would strip the nation of its top ranking over the next two years.
The ratio of net government debt to GDP reached 72 percent in 2011 and will rise to 80 percent by 2015, John Chambers, managing director of sovereign ratings at S&P, said in a speech in Beijing last month. The government’s reliance on foreign investors contributed to the downgrade, he said.
Germany’s debt-to-GDP ratio will fall to 65.6 percent by 2014 after peaking at 72.7 percent at the end of this year, according to a Bloomberg Brief estimate.
“The U.S. needs to raise its savings level,” Chambers said, according to a transcript of the speech on S&P’s website. “Failure to do so might raise the vulnerabilities to shifting non-resident investor sentiment.”
John Piecuch, an S&P spokesman, said the company wouldn’t make its sovereign analysts available for comment.
When S&P lowered its outlook for the U.S. in April, it cited the dollar as a reason to keep the top grade, referring to it four times in a statement. In its Aug. 5 announcement of the downgrade, the company mentioned it only once, in the 15th of 20 paragraphs.
S&P justified the move by saying “the effectiveness, stability, and predictability of American policymaking and political institutions have weakened.”
The U.S. has the world’s top reserve currency, with central banks keeping 60 percent of their foreign-exchange holdings in dollars, down from 72.7 percent in 2001, according to the International Monetary Fund in Washington. America is able to print its own currency, unlike the 17 nations in Europe using the euro, which gave that authority to the European Central Bank.
That means the U.S. has the ability to create cash to pay its debts or devalue to boost imports.
“We don’t have to worry so much about our government becoming dysfunctional as we have to worry about that damn printing press becoming dysfunctional,” billionaire Warren Buffett, Berkshire Hathaway Inc.’s chairman and chief executive officer, said on Aug. 16 in a television interview with Charlie Rose. “There are 17 countries in Europe that gave up the right to print money, and believe me they know what it means to give up the right to print money.”
Buffett, the biggest shareholder of S&P rival Moody’s Corp., said after the S&P downgrade that the U.S. should be “quadruple-A.” John Bellows, then the acting assistant Treasury secretary for economic policy, said S&P made a $2 trillion “mistake” in its math and then changed the rationale for its decision to politics. S&P denied it made an error or altered its reasoning.
S&P said two weeks after the reduction that it would replace Deven Sharma, its president, with Douglas Peterson, a Citigroup Inc. executive. David Beers, head of sovereign ratings, said last month he was leaving to join the Bank of Canada next year. Mark Adelson, who oversaw S&P’s methodologies, was shifted to a research position on Dec. 9.
“The rating downgrade was a political message,” David Kotok, chief investment officer at Cumberland Advisors Inc., said on Dec. 7 in an interview with Sara Eisen on Bloomberg Television’s “InsideTrack.”
While marketable U.S. government debt has risen to $9.4 trillion from $4.34 trillion in mid-2007 as the government borrowed to bail out the nation’s banking system and lift the economy out of recession, the amount of Treasuries outstanding makes them easier to trade, according to Michael Cirami, a money manager at Boston-based Eaton Vance Corp. (EV)
“People want to hold them because they’re very liquid and because they’re among the safest assets that one can hold,” Cirami, whose firm invests $13.2 billion, said on Dec. 13 in a telephone interview. “If you downgrade the U.S. from AAA to AA+, it doesn’t change the liquidity of Treasuries.”
Though the U.S. went from budget surpluses averaging $139.7 billion from 1998 through 2001 to a deficit of $1.29 trillion last year, the country’s borrowing costs have fallen.
Average debt yields dropped to 1.04 percent as of Dec. 14 from 1.5 percent in July and 6.54 percent in 2000, Bloomberg data show. The average yield on all types of dollar-denominated debt fell to 2.11 percent on Dec. 8, according to the Bank of America Merrill Lynch U.S. Broad Market Index.
That compared with 2.51 percent for the firm’s Global Broad Market, Ex-U.S. Dollar index. Yields on bonds from elsewhere were lower as recently as May 12, when they averaged 2.74 percent versus 2.76 percent in the U.S.
“The U.S. is still the place to park assets,” Scott Kimball, who manages $7 billion of bonds at Taplin Canida & Habacht LLC in Miami, said Dec. 7 in New York. “It is still the strongest credit in the global financial markets.”
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