From an institutional trading desk:
S&P’s revision to the outlook on the United States’ sovereign credit rating to negative from stable this morning provoked a wide range of reactions. Not terribly significant in the sense that the outlooks on issuers’ credit ratings are revised up and down by the ratings agencies every day, and not terribly significant in the sense that the markets didn’t move all that much, the revision has nonetheless touched a nerve. Why?
For starters, it is the first admission by what I call “officialdom” that the means by which we extricated ourselves from the debt deflation of 2007-09 carry negative consequences. Who knows if the big swings in the market are caused by shifts in the dominant narrative or whether the narrative shifts in response to the swings in the market, but either way today’s action by S&P introduces a new narrative into the mix. This crisis isn’t over; it’s just entered into a new phase. This was never a mere cyclical recession anyway and now we have a choice: tighten our belts to preserve our preeminent financial standing in the world, or roll the dice on further policy accommodation at the risk of the a debilitating, Greece-like implosion.
That’s a far cry from the present dominant narrative which goes something like this: Short-termism of the kind displayed during last December’s “budget compromise” is irresponsible and will cost us dearly at some point, but it also symbolizes policymakers’ desire to do “whatever it takes” in the short term in order to keep this recovery going. Don’t fight these policymakers – at least, not until after the 2012 elections.
One of these narratives is bearish for financial asset prices and one of them is bullish. No prizes for guessing which is which.
Secondly, should an actual downgrade of the U.S.’s issuer rating to AA+ materialize, and should it be followed by downgrades by Moody’s and Fitch, there are all sorts of question marks about what kind of friction would result from institutional rigidities. For example, many institutions around the world have mandates to invest certain percentages of their funds in AAA securities. Presumably, downgrades by two or three of the agencies would spark a good deal of selling by those institutions.
What about Treasuries’ hypothecation value? If they’re not AAA anymore, would they be accepted as collateral in the repo market on the same terms that are offered today? Or, would extra collateral need to be posted – or would the interest rate charged need to rise? What effect would this have on liquidity, on the very “money-ness” – to borrow Doug Noland’s term – of Treasury securities? Male model Derek Zoolander once said, “Water is the essence of wetness, and wetness is the essence of beauty.” Likewise, 100% hypothecation value is the essence of risk-free, and risk-free is the essence of moneyness. In Minskian terms, a decline in the moneyness of Treasuries would make it more difficult for levered entities to “make position” which in turn would make the financial system more fragile, more susceptible to crises.
I’ll go one step further: this revision, this oh-so-minor revision, is in fact a policy tightening. Despite the fact that several additional steps would need to be taken by the ratings agencies before any of these liquidity difficulties came to pass, I believe that the shock of today’s announcement amounts to a more significant policy tightening than that which will occur in June when the Fed ends QE2. The end of QE2 is part of a carefully prepared script and therefore will have no real impact on market participants’ behavior (by design). Besides, quantitative easing produces diminishing returns (it puts cash assets on banks’ balance sheets, enhancing their ability to make position, but relaxed FAS 167 guidance has already alleviated any difficulty in making position by absolving the really bad assets from mark-to-market accounting) which means that ending QE2 will not be significant in the context of financial sector liquidity.
Check out the chart below which shows the implied yield difference between 3-month Eurodollar futures and the 3-month overnight index swap (a proxy for interbank lending risk) on an intraday basis going back about a month. It shows that the yield difference spiked about 3 basis points higher on the heels of S&P’s announcement this morning.
It’s not an insignificant move, that 3 basis point spike, but the chart above on the right puts it into context. If I’m right and S&P’s announcement does in fact constitute an actual policy tightening, it either hasn’t hit full bore yet or it’s simply a very slight tightening. This context is important because even the cleverest theories amount to nothing if there’s no follow-through in the markets.
However, if, after the political and financial establishment gets done telling us all to quit our worrying and that today’s action by S&P has no practical significance, traders get to thinking about the very real implications this action has for financial instability in the future (and traders are forward-looking, right?), we might be looking at a downside catalyst for risk assets including stocks.
At this point, I want to soak up any and all arguments the conclusion of which is that S&P’s revision is not significant before revising my own near-term bullish stance. It was definitely an unnerving day, though, wasn’t it? Between that and the European difficulties (the True Finns!), it’s a testament to traders’ undying optimism that the market managed to pare nearly half of its losses in the afternoon.