Much ado about a downgrade

08.26.2011 - Capital Markets

On August 5, 2011, Standard & Poor’s (S&P) lowered theUnited States long-term sovereign credit rating from AAA to AA+.  This led to a massive worldwide sell-off of equities the following week and the subsequent market turmoil that continues.

S&P also concluded that the outlook for the long-term rating was negative.  Not surprisingly, the primary reason cited for the downgrade was the Congressional gridlock over raising the debt ceiling and the lack of a plausible plan to reduce the budget deficit.  There has been much debate as to whether the downgrade was warranted and that debate will no doubt continue for some time.

What was clear though, was that the bond market did not downgrade the U.S. Treasury market. There was a flight to safety as money flowed into U.S. Treasuries, raising prices and causing interest rates to fall.  The 3 month and 6 month Treasury Bills are yielding .01% today.  The 2 year and 5 year Treasury Notes are yielding .18% and .93% respectively.  And, the 10 year Treasury bond is yielding 2.19%.

More than likely the flight to safety can be attributed to worries about the global economic outlook as well as the long running financial crisis inEurope.   During the last few years, many yield-starved domestic money market funds had been buying the dollar denominated commercial paper of the large European banks.  Lately, however, with the uncertainty surrounding the financial soundness of European banks the appetite for these securities has declined sharply.

According to the Bank for International Settlements, large European banks, particularly those ofFranceandGermany, hold a vast amount of European sovereign debt. Greeceis effectively bankrupt and will not be able to repay its debts in full. IrelandandPortugalare in similar straits.  While certainly not in as dire condition, interest rates forItalyandSpainhave increased appreciably.  Recently, the European Central Bank began purchasing bonds ofItalyandSpain,  the third and fourth largest European economies, to stabilize the market from the fear of contagion.  The lack of confidence for a quick solution has caused the cost to insure French sovereign debt against default to jump to record levels.

Most analysts are of the opinion that European banks will need to raise capital in the near future.  During the depths of the financial crisis,U.S.banks were forced to raise significant amounts of capital to repair balance sheets that were riddled with troubled assets.  European banks, on the other hand, did not act swiftly and will soon have to pay the piper for their dalliance.  The lack of aggressive action has provided the momentum that is leading the market downward in an economy clearly weakening.

Financial markets detest uncertainty.  Expect the volatility of recent weeks to continue until such time as the European Union leaders put in place a comprehensive plan to resolve once and for all the sovereign dept crisis.  The crisis has festered for the past two years without a credible solution.  If not resolved soon the nascent economic recovery will in all likelihood continue to be muted – at best.  At worst – it might be tipped into another recession.