Aug 8, 2011

S&P Downgrades US Debt!

August 8, 2011

"Some people just make too much money."--unnamed Democrat during debt ceiling negotiation, according to Eric Cantor.

It’s risk off to begin today’s trading after Friday evening’s rating cut of US Treasury debt by S&P. The rating agency, which was woefully behind every stage of the mortgage crisis, cut the debt rating of the US, adding fuel to an already burning fire in the global markets. Trading looks like risk off as equity futures are down hard again today, the Swiss Franc is strong (which is now the safe-haven currency), gold is up, the dollar is up, and the recently down-graded treasuries are rising. Commodity markets are getting ripped, with the CRB down 4%. Oil is leading the way down, falling another 3% as the WTI now sits below $84. To me the irony is that the decline in oil, if sustained, may provide a bigger boost to consumer spending and the economy than QE2, which helped push oil prices up.

It’s important to note that the downgrade did not question the US ability to meet its obligations in the short or intermediate term. Their concern related to the ongoing ability of our political structure to make the decisions necessary to curb ever-rising government debt, citing the inability of the recent negotiations on the debt ceiling to lower the long term deficit. A true lack of leadership has emerged in Washington which is exacerbating an extremely difficult economic environment. When the crisis evolved three years ago, Washington put in a number of short term, stop-gap attempts to reignite the economy. Unfortunately, very little focus was given to making longer term, structural changes that by now should be taking hold. We are left in a position of once again yearning for short term fixes, without a long term plan in place. As we all know, short term fixes tend to be very expensive and not always effective.

One risk worth monitoring going forward will be weakness in non-government and municipal credit markets.

An oft rumored story circulating through the markets has focused on forced selling by holders of US Treasury debt after a downgrade. It is important to note that this downgrade will impact very few holders in that manner because, in spite of its cut, the debt is still considered investment grade.

The German DAX just reached bear market status, defined as a decline of 20% or more. As bad as things look here in the US, things in Euroland are much worse. The ECB is now aggressively buying Italian and Spanish bonds in an effort to stave off a credit crisis in those countries and another financial contagion across Europe and beyond. Estimates of a $1.2 trillion commitment from the ECB have the markets extremely spooked. Germany, the keel of European finance, faces a lack of political will from its populace, which will keep a damper on their continued ability to provide support to the rest of the continent. The ECB has promised to do “anything necessary” to keep the financial markets functioning.

Sean Egan of rating agency Egan Jones is concerned about the ECB as he feels they are now levered 60-1 off their capital base. For most central banks leverage ratios are somewhat irrelevant because of their ability to print currency to meet their obligations. However, a 60-1 ratio does show how far the ECB has had to go to help the periphery countries.

When market participants are all in agreement, it’s often best to run the other way, or at a minimum question the conclusion. The table below shows the year end price targets for the S&P500 from the leading brokerage firms. This is a very tight range, and while 1400-1420 could still come to fruition, the market needs to rally over 20% to hit those levels. That would be a nice way to end the year. Thanks to Invictus and The Big Picture for the table below.

Credit default swaps on Bank of American and Goldman Sachs have jumped to the highest levels since 2009 on concerns that their credit rating may also be cut. Bank of America is now trading at 40% of book value, indicating that the market feels the loans in the BofA portfolio are worth dramatically less than stated.

Treasury Secretary Timothy Geithner has agreed to stay with the Administration until 2012. President Obama asked the secretary to stay given the difficulty of the current crisis.

A helicopter carrying at least 30 US servicemen was shot down over the weekend in Afghanistan, resulting in the deadliest day of fighting for US troops since that war began.

The Sox took two of three from the Yankees, and remain a game ahead in the AL East. A bit closer to home, the Angels beat the Mariners 2-1 last night to remain a game behind Texas.

Yesterday created another humbling afternoon at home as I mentioned to my youngest son I was going to bed a bit early last night to prepare for what could be a hard day at work. He said “what you do really isn’t that hard, right? I mean, you don’t sweat. You just type.”

Have a great day


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