US long Term Sovereign Rating Downgrade Impact

08 August 2011

It is important to remember that US long-term rating is downgraded by S&P but still regard as an Investment Grade while two other CRAs reaffirmed AAA rating. After the lost of AAA rating, borrowing cost will increase for the US treasuries, which result in higher debt service cost and more burden on already high fiscal deficit. Pressure will also mount on all those sovereign who have pegged their currencies with USD, including Hong Kong & Gulf countries (except Kuwait) Does the investor have choices other than US Treasuries? There is no doubt that US treasuries were and will remain the most liquid benchmark. There is a dearth of alternative AAA investments, as of now US treasuries stock are much bigger than the cumulative treasury stocks of those, considered to be the alternative to US treasuries. Even after adding all the outstanding treasury stocks of Germany, France & UK, its only 42% of US treasuries stock (excluding MBS) US Treasuries (USD11, 150 bn) > Germany Treasuries (USD 1,720 bn) + France Treasuries (USD 1,700 bn) + UK Treasuries (USD 1,300 bn) We also know the fiscal woes of these European countries; especially the uncertainty exists regarding the sovereign debt crisis in the region which may aggravate the fiscal troubles of these countries. Therefore, in short to medium term, I dont see change in investors behavior for US treasuries by large. Albeit, we could see the increase in yields of US treasuries, which is negative for US govt. , however, positive for those investors who were complaining low returns for holding US treasuries. Take the example of Japan: when Japan lost its AAA status, in February 2001, 10 year yields rose 9 bps on the day, however by the end of the week it was 2bps lower. Events to watch: The first meeting of Feds policy-setting Federal Open Market Committee (FOMC) after the downgrade will announce its assessment of the current economic conditions and outlook on Tuesday (Tomorrow) to be watchful. Just to refreshing the memory, Fed chairman Bernanke on July 13 said that the Fed is prepared to respond if more stimulus is needed. Nevertheless, next quantitative easing program will only introduce when Fed would think that its deem necessary for US economic growth & its labor market, not to calm the panic in the capital markets. I also believe that next any quantitative easing program will not be a replica of earlier QE1 and QE2 because it largely failed to address the growth and labor problems In the short term, funding markets will remain under pressure, worldwide. For US equities, historical risk premium is no longer effective, since default risk free status has changed. I am long on Gold while seeing continuous pressure on crude oil and other commodities. Declining crude oil prices will have serious implications for Oil exporting countries especially whose economy & government revenues are dependent on oil revenues like Middle Eastern countries while positive for all oil importing countries, largely better for Asian economies because of lower inflation and less pressure on external account. I see prolong pressure on US dollar, however the biggest alternative Euro in given sovereign debt crisis is no longer bank-able option. It is also to remember that historically, dollar is negatively correlated with the risky assets. If we agree that, nothing is absolute, then on a relative term, US is still a better option, for now.

I also believe that now there is a more urge among investors to diversify their investments across different asset classes and diversify portfolio on Global scale.

Muhammad Irfan Khaliq is an Investment Analyst, can be reached at hakaiun@gmail.com