Some Thoughts On The S&P Move

The key takeaway from the S&P announcement is that the US has been put on notice, but no ratings action are likely until 2013. With no one expecting any serious progress on deficit reduction until after the 2012 election, S&P seems to be simply firing a shot across the bow to US policy-makers. Agency officials say a downgrade is not inevitable, but put the chances at “one in three” with this action. With regards to our sovereign rating model, the United States is a special case and deserves a mention. Despite expanded budget deficits and increased debt issuance, we still see the US as an AAA credit. Because the dollar is the world’s reserve currency (and will remain so for years to come), the US simply gets more leeway from the ratings agencies than other countries with regards to policy risks. We have a dummy variable that accounts for this in the ratings model, and we acknowledge that removing this favorable factor for the US would put it into borderline AA+/Aa1/AA+ territory.

To us, the S&P statement means that the agencies do not have unlimited patience with regards to US fiscal policy and the rising debt load. We note that the IMF recently revised up its deficit forecasts as a percentage of GDP for 2011 and 2012 to -10.8% and -7.5% from -9.7% and -6.6% of previously. The 2011 US forecast is the highest in DM, though the 2012 forecast has Japan overtaking the US as the worst in DM with -8.4%. US CDS price is up 6 bp to 50 bp on the day, while UST yields are mixed with 2-year down 5 bp and the 30-year up 7 bp. The euro is back near the lows of the day after the knee-jerk buying after S&P news hit the tapes, and so all in all, it would appear that markets are digesting the news.

We do know that rating agencies have inserted themselves into US budget debates before, with Moody’s putting some USTs on review for possible downgrade (much stronger than negative watch) back in 1996. Why? That was during another budget impasse after Republicans refused then to vote to increase the debt ceiling. Back then, markets seemed to recognize the move for what it was, which was an effort to force the White House and Republican Congressional leaders to get a deal done. We suspect similar motivations are behind today’s move.

Back in May 2009, S&P put its AAA rating for the UK on negative watch for a possible downgrade. Then too, S&P said that the chance of a UK downgrade was “one in three.” However, the agencies were split as Moody’s weighed in that year and said the UK’s trajectory would remain consistent with AAA/Aaa countries. S&P affirmed the AAA UK rating back in July 2010 after the new government committed to austerity measures, but kept the negative watch on then if it didn’t stick to the ambitious deficit reduction plans. Then in October 2010, S&P revised the outlook to stable from negative, and so proves that the negative watch does not automatically lead to a downgrade. However, the UK did take aggressive measures and so US policy-makers must know that the current trajectory must be changed. The US does, however, have a slightly longer window of opportunity than perhaps the UK might have had. One last point is that our ratings model still has the UK improving slightly but still in AA/Aa/AA territory, where we have had it since mid-2009.