Treasury Slide May Be Short-Lived

U.S. downgrade likely to be offset by EU debt crisis, slower growth.

Any selloff in Treasuries and the dollar following Standard & Poor’s first ever downgrade of the U.S. from AAA is likely to be short-lived amid slowing economic growth and Europe’s debt crisis, according to Wall Street banks.

JPMorgan Chase & Co. said a drop in Treasuries from the ratings cut is unlikely to be “sustained,” while Citigroup Inc. said dollar selling isn’t forecast to be entrenched. Barclays Plc said the downgrade shouldn’t be “significant,” and UBS AG said the top ranking for U.S. short-term debt will prevent money funds from being forced to react.

For all the handwringing over the credit-rating cut, bond investors from Wall Street banks that trade directly with the Federal Reserve to policy makers in China and Russia are likely to retain their holding of Treasuries as they see few alternatives to the world’s deepest and most liquid market. The dollar remains the world’s reserve currency even as S&P cut the U.S. one level to AA+ while keeping the outlook at “negative” on Aug. 5, citing the political failure to reduce record deficits while Moody’s Investors Service and Fitch Ratings affirmed their AAA credit ratings for the U.S. on Aug. 2.

“The markets are pretty well braced and have priced this in,” said Laura LaRosa, director of fixed income at Philadelphia-based Glenmede, which oversees $20 billion. “Certainty, we would not cut our Treasury holdings on the S&P downgrade. We don’t think there’s going to be a huge violent swing.”


Buffett, Greenspan
Billionaire Warren Buffett said in an interview with Betty Liu at Bloomberg Television that S&P erred when it lowered the U.S. credit rating and reiterated his view that the economy will avoid its second recession in three years. The nation merits a “quadruple A” rating, Buffett, 80, said Aug. 6.

Former Fed Chairman Alan Greenspan, speaking on NBC’s “Meet the Press,” said that U.S. government bonds are safe investments. “Very much so,” he said Aug. 7.

The cost to insure U.S. debt against default is less than that of AAA rated Germany, France, Australia and the U.K., according to data provided by CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.


Default Protection
Credit-default swaps that protect against default on U.S. notes for five years fell 11 percent last week to 55 basis points, before rising to 58.5 basis points today, CMA data show. That compares with an increase last week of 15.6 percent to 74 for swaps linked to Germany, an 18.2 percent climb to 144 for France, a 21.5 percent rise to 69 for Australia and a 4.5 percent weekly increase to 77 for U.K. government securities.

Yields on 10-year Treasury notes dropped 24 basis points last week or 0.24 percentage point, to 2.56 percent after falling as low as 2.33 percent on Aug. 5, according to Bloomberg Bond Trader prices amid signs of stalled economic growth and a widening sovereign-debt crisis in Europe. The yield was at 2.48 percent today.

The two-year U.S. note yield dropped seven basis points to 0.29 percent last week and was at 0.25 percent today. It touched a record 0.2527 percent on Aug. 4.

Treasuries have returned 5.29 percent this year, according to Bank of America Merrill Lynch data, outperforming the 4.63 percent decline in the Standard & Poor’s 500 Index.

JPMorgan said 10-Treasury yields will likely increase to 3 percent by the end of the year, compared with an earlier forecast of 3.5 percent, on a “poorer growth outlook,” according to an Aug. 5 report from analysts led by Terry Belton, global head of fixed-income and foreign-exchange research.


Investor Comfort
“We do not anticipate forced selling of U.S. Treasuries from any significant investor base,” Barclays analysts Ajay Rajadhyaksha and Anshul Pradhan wrote Aug. 6 in a research report. “U.S. Treasuries remain the flight-to-quality asset class of choice, and we do not believe S&P’s action will change that in investors’ minds.”

S&P lowered the U.S. rating as it becomes less confident Congress will end Bush-era tax cuts or tackle entitlements. The ranking may be cut to AA within two years if spending reductions are lower than agreed to, interest rates rise or “new fiscal pressures” result in higher general government debt, the New York-based firm said.

“The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics,” S&P said in a statement late on Aug. 5 after markets closed.


Ratings Review
While Moody’s and Fitch affirmed the top AAA rating for the U.S., they said downgrades are possible if lawmakers fail to enact debt reduction measures and the economy weakens.

Lawmakers agreed on Aug. 2 to raise the nation’s $14.3 trillion debt ceiling and put in place a plan to enforce $2.4 trillion in spending reductions over the next 10 years, less than the $4 trillion S&P had said it preferred.

On a conference call on Aug. 6 with reporters, S&P analysts David Beers and John Chambers said that in their analysis, the “extremely difficult” political discussions in Washington over how to reduce the more than $1 trillion budget deficit carried more weight in their decision than the nation’s outstanding debt. It said the talks weren’t “consistent” with a AAA rating.


Long-Term View
There may be “long-term implications” if the markets agree with S&P that the U.S. has become less creditworthy, eroding its role as the world’s reserve currency, Barclays said. Borrowing costs may rise about 25 basis points and spur investors to “increase diversification away” from the dollar.

Asian investors are likely to retain their Treasuries holdings for now, with options limited by the region’s foreign-exchange rate policies. Japan, the second-largest international investor in American government debt, sees no problem with trust in the securities, a Japanese government official said on condition of anonymity. Russia said the one-step cut “can be ignored.”

Policy makers from China to Japan to Southeast Asia are lured to Treasuries as a result of efforts to stem gains in their currencies against the dollar, which would impair export competitiveness. China has accumulated $1.16 trillion in the securities and the nation’s official Xinhua News Agency said in a commentary that the U.S. must cure its “addiction” to borrowing.


No Sale
“Foreign official institutions are likely to be particularly loath to sell Treasuries,” Citigroup analysts Todd Elmer, Steve Englander and Greg Anderson wrote in a report. “Foreign official institutions represent the single largest holders of Treasuries, which means they are most exposed to the ratings downgrade, but politically they are unlikely to want to introduce additional volatility into the market and it would be difficult for them to join in with private sector sellers of U.S. securities.”

The dollar rallied last week versus 15 of its 16 most-traded counterparts as concern the world’s largest economy is stalling and Europe’s debt crisis is worsening damped demand for higher-risk assets. The greenback was up versus 12 of its 16 today.

Italian Prime Minister Silvio Berlusconi vowed the nation will accelerate financial reforms. The move came before the European Central Bank was said to be buying Italian and Spanish government bonds today to help stave off the debt crisis.

The committee of bond dealers and investors that advises the U.S. Treasury said the dollar’s status as the world’s reserve currency “appears to be slipping” in quarterly feedback presented to the government on Aug. 3.


Reserve Currency
The U.S. currency’s portion of global currency reserves dropped to 60.7 percent in the period ended March 31, from a peak of 72.7 percent in 2001, data from the International Monetary Fund in Washington show.

“The idea of a reserve currency is that it is built on strength, not typically that it is ‘best among poor choices’,” page 35 of the presentation made by one member of the Treasury Borrowing Advisory Committee, which includes representatives from firms ranging from Goldman Sachs Group Inc. to Pacific Investment Management Co. “The fact that there are not currently viable alternatives to the U.S. dollar is a hollow victory and perhaps portends a deteriorating fate.”

Members of the TBAC, as the committee is known, which met Aug. 2 in Washington, also discussed the implications of a downgrade of the U.S. sovereign credit rating. “None of the members thought that a downgrade was imminent,” according to minutes of the meeting released by the Treasury.


S&P Top
S&P gives 18 sovereign entities its top ranking, including Australia, Hong Kong and the Isle of Man, according to a July report. The U.K. which is estimated to have debt to GDP this year of 80 percent, 6 percentage points higher than the U.S., also has the top credit grade. In contrast with the U.S., its net public debt is forecast to decline either before or by 2015, S&P said in the statement yesterday.

New Zealand is the only country other than the U.S. that has a AA+ rating from S&P and an Aaa grade from Moody’s. Belgium has an equivalent AA+ grade from S&P, Moody’s and Fitch.

The downgrade by S&P “may well raise questions about other members of the dwindling AAA club,” Mohamed El-Erian, the Newport Beach, California-based chief executive officer and co- chief investment officer at Pimco, the world’s largest manager of bond funds, wrote in an e-mail.

“Investors should be cautiously positioned as the global economy and markets face major uncertainties,” El-Erian wrote. “The downgrade will be a further headwind to growth and job creation in the U.S.”


Bloomberg News

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