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US Treasury yields likely to rise over the long-term, says Standish's Higgins
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The US economy remains fragile, and a return to recession can't be ruled out
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In the Eurozone, fire-fighting continues but decisive action still needs to be taken
Tom Higgins, global macroeconomic strategist at Standish, reacts to the news of the US' credit rating downgrade and looks at the likely ramifications.
Last Friday saw the significant downgrade of the US credit rating by Standard and Poor's (S&P) from AAA to AA+, prompting criticism from President Obama over the agency's rationale behind the decision, and strong rebukes from both the Indian and Chinese governments regarding the US government's approach to fiscal responsibility.
"Markets reacted negatively to the news, which is understandable given that these are unprecedented times," says Higgins. "Perversely, the uncertainty that has followed the downgrade has actually triggered a flight to quality into US Treasuries, with the 10-year Treasury yield falling to its lowest level since January 2009. S&P also downgraded the US government-backed mortgage agencies Fannie Mae and Freddie Mac in line with that of the US government. This may have a negative impact on the US housing market in the long-term in so far as it raises borrowing costs for the agencies. However, even at AA+, it must be remembered that the US has never defaulted on its debt, and the likelihood of that happening remains very slim," he adds.
"Thus far, the downgrade of US government debt from AAA to AA+ has had limited implications for most fixed income investors." Higgins explains, "Ahead of the announcement, there were some concerns that a downgrade could lead to forced selling of Treasuries or other lower quality securities by financial institutions and fixed income accounts which had average credit quality restrictions. However, the US Federal Reserve mitigated these risks by immediately announcing that US Treasuries and government agency debt would still be classified as AAA for risk-adjusted capital purposes. At the same time, most fixed income accounts simply changed their guidelines to allow for the change in the US credit rating. As a result, there was little, if any, forced selling of Treasuries.
"Indeed, they continue to be viewed as a safe haven, regardless of last week's events, especially for US investors. However, in the long-term, after all the dust settles, Treasuries may trade at yields that are 50-75 basis points higher than they would have been in the absence of a downgrade." he says.
Eastern rebuke
"China reacted to news of the downgrade with strong criticism of the US, and while we feel that these comments were ultimately politically motivated, they weren't without foundation. Even Obama, in his statement about the credit downgrade, recognised that the US was being punished for its policy mistakes and lack of political decisiveness," Higgins explains. "However, given the political stalemate in the US, it seems unlikely that there will be any more fiscal reform before the November 2012 Presidential election - not ideal given that the US remains on negative watch from S&P. There is no doubt that the downgrade will do little to help the US' already fragile economy and we believe that there is a 30-40% chance of another recession in the US. The low trajectory of real GDP growth suggests that the economy is highly vulnerable to shocks including the impending US fiscal contraction and any worsening of the European sovereign debt crisis."
He continues, "The events of the past week have led to renewed calls for further quantitative easing (QE). Indeed, the Federal Open Market Committee's statement on Tuesday recognised that the ‘downside risks to the economic outlook have increased' and confirmed that the committee would be prepared to employ policy tools ‘as appropriate'." He adds, "The problem is that the US Federal Reserve (Fed) has very few weapons left in its armoury, so the timing of any such move would be the key. The Fed announced that it would keep rates on hold until 2013 in an effort to combat renewed weakness in the US economy, but three Fed governors dissented from the decision, suggesting that there is not yet full support for more aggressive policy action, such as a third round of QE. However, we would expect to see another round of QE by early 2012 given the fiscal drag that is likely to result from the recent budget agreement. In order to be effective, QE3 would have to consist of at least another US$1 trillion in Treasury purchases by the Fed. Unfortunately, even if we get this, we do not believe that QE3 will be as effective as the prior two rounds and the risks of a Japanese-style liquidity trap, in which monetary and fiscal policy are ineffective at boosting economic growth, are rising," Higgins warns.
"The downgrade is likely to have implications for the US dollar too. While we have seen short-term US dollar strength relative to the euro, we would expect QE3 to reverse that. Ultimately, we would expect to see a weaker dollar over the long term, something which will be tentatively welcomed by China, although a sell-off in Treasuries would not be welcomed given China's US$1 trillion exposure US government debt," Higgins adds.
Eurozone fire-fighting
"Across the Atlantic, the Bank of England has admitted that it's running out of tools with which to fight inflation, while the European Central Bank made a statement on Sunday night announcing that it planned to buy Italian and Spanish government bonds. We maintain that any such move is merely a short-term measure," he says. "A restructuring of Greek debt is required, a long-term funding solution is necessary, while an expansion of the European Financial Stability Fund (EFSF) and broad fiscal agreement within the region are also essential. Of these, we think that an expansion of the EFSF would be the most preferable for the all-important German government and that if it were to be expanded to around US$1 trillion then that should be sufficient to overcome the fundamental problem of a lack of fiscal union." Higgins continues, "Any funding would be delivered through Eurozone bonds while the EFSF would still be able to buy in the secondary market. This would provide a concrete long-term solution, rather than the current short-term plans in place.
"That said, there are doubts over the expansion of the EFSF, given that an expansion would probably trigger Italy and Spain to seek help, meaning that they would cease to contribute to the fund, and therefore placing greater burden on the rest of the single currency area," he explains. "However, we believe that the core of Europe needs to take the worst of the strain, much like in the US where wealthier states take some of the burden from their less wealthy peers. Furthermore," Higgins concludes, "the EFSF does not involve direct country to country loans, and we think that this is likely to be much more palatable for the governments and electorate in the core Eurozone countries."
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