How To Tell A Market Commentator Doesn’t Understand Markets or Finance or What They’re Talking About

It’s Monday, Aug 9.  The stock markets are declining significantly, although anybody who says it’s panic doesn’t remember 2008.  Anyway, lots of market commentators, you know the types on cable TV news networks, are all claiming the decline is due to the S&P downgrade.  They’re wrong. Completely wrong as I pointed out already. But just to reinforce my point, here’s Paul Krugman just minutes ago:

Carnage in stock markets as I write — and all of the headlines I see attribute it to S&P’s downgrade.

They really are trying to make my head explode, aren’t they?

Once again: S&P declared that US debt is no longer a safe investment; yet investors are piling into US debt, not out of it, driving the 10-year interest ratebelow 2.4%. This amounts to a massive market rejection of S&P’s concerns.

The “signature” of debt concerns should be stock and bond prices both falling; what we actually see is those prices moving in opposite directions. And that’s normally the signature of concerns about a weak economy and deflation risk (see Japan, decline of).

What triggered economy fears? To some extent I think this is a Wile E. Coyote moment, with investors suddenly noticing just how weak the fundamentals are. Also, the mess in Europe.

And maybe, maybe there is an S&P story — but not the one you think. Arguably, that downgrade will bully policy makers into even more deflationary, contractionary policies than they would have undertaken otherwise, which has the perverse effect of making US debt more attractive, since the alternatives are worse.

But all the Very Serious People, having totally misdiagnosed our problems so far, will probably double down on that wrong diagnosis as markets fall.

Oh by the way.  The 10 year bond rate is now down to 2.38% from 2.6% on Friday.  The  3 month and 6 month rates are less than 0.01% – essentially zero interest rate.

The Market Shrugs Off Rating Downgrade, Market Is Worried About Real Economy.

It’s now Monday morning, Aug 8.  It’s been roughly 60 hours since S&P downgraded the rating on U.S. government bonds.  In that 60 hours the media, particularly TV talking head channels, have been breathlessly awaiting what they felt was a certain market panic on Monday. Clearly interest rates would go up they said.

They were wrong.  The early results are in.   U.S. government bond prices have  gone up this morning!  That means government bond yields (interest rates) have actually gone down!  The 10 year bond actually dropped from 2.6% yield on Friday’s close to 2.48% at 9:30 am ET on Monday.

It’s really no surprise if you pay attention to real economic events and not listen to the TV media types who think talking in serious tones is a substitute for actually understanding economics.  First, serious investors, the ones who vote with their money in the market already know everything that S&P knows.  In fact, they know S&P has a really bad track record. So the rating doesn’t mean much to them.

What does matter is what choices or alternatives they have for investing their money.  Right now, the signs from the real economy in both the U.S. and Europe are grim.  Europe is struggling to achieve any growth outside Germany with several major economies actually declining due to their governments’ embrace of budgetary austerity.  The U.K. is on the ragged edge of another recession, again due to government cutbacks. The U.S. is barely registering postive growth with only 0.8% growth rate in the first half of 2011.  It’s clear, too, from the debt ceiling debate that the U.S. won’t be seeing much stimulus anytime soon and likely will join the Europeans in austerity budget cutting. Cutting that will only slow the economy further and possibly drive another recession.  So what theses investors know is that economic growth isn’t likely and that’s bad for stocks.  Stock markets aren’t the place to be now.

Further, Europe is continuing it’s slow-motion debt default crisis issues.  In the past week or so the crisis has spread beyond Greece, Ireland, and Portugal. Now it’s Italy and Spain too.  Even AAA-rated France is finding it’s bonds trading at significantly raised interest rates.  Now the debt crises in Europe are real problems because the nations inside the Euro zone don’t have control over their own currency, they don’t have a central bank, and they borrow in some other currency (Euro) rather than one of their own.  This is unlike the U.S.  The problem is the uncertainty the debt crises in Europe are creating.  The global financial and economic system is once again showing great signs of weakness, fragility, and uncertainty – just like 2007 and 2008.

When uncertainty abounds and about the only sure thing is that growth will be weak at best, it’s time to put your money in something safe and wait it out.  The safest thing in the world (in any volume) is still U.S. government bonds.  So what we have is investors moving into U.S. government bonds because they don’t want to be in anything else.  Everything else is too risky.  So we get increased demand for U.S. bonds and that lowers interest rates on those bonds. This is what financial analysts and economists call a “flight to safety”.

The S and P Downgrade Decision Stinks of Politics and Corruption.

Yves Smith at Naked Capitalism (an unusually good source of very in-depth, timely commentary) offers some strong evidence and analysis of how the S&P decision to downgrade the U.S. debt stinks.  I’ve already talked about how it’s really irrelevant at the economic level and how it’s not likely to change things substantially.  I’ve also written about how S&P doesn’t have a very good track record.

But Yves, who has extensive connections on Wall Street and in the trading/banking community, brings two other aspects to light. First, this downgrade, along with the threatened downgrade of a few state governments earlier this past week, was leaked before the announcement.  The proper procedure is to make such announcements after the close of markets and to not allow any leaks.  Leaks constitute insider information.  They let selected individuals make profits because they know what’s coming.  For example, as Yves suggests, if some traders or banks or others were told in advance, even just a few hours ahead that a downgrade announcement would be made, they could make millions.  How?  They could either place orders, particularly using derivatives, in anticipation of the move.  After the prices of bonds change due to the announcement, you sell.  But there’s a simpler way.  Just place an investment bet using the derivatives that based on the volume of trading.  Any announcement is certain to trigger a higher volume of trading.  Leaking news of announcements is an easy way for S&P to enrich it’s favorite friends. Yves notes:

Treasury yields fell 50 basis points last week despite the risk of a downgrade being very well telegraphed. S&P had asked for $4 trillion in deficit reductions (it tried disavowing that number) and made it clear it was going off to brood and might take action. And this market response took place with S&P leaking like a sieve. Not only was Twitter alight early on Friday with rumors of the downgrade, but some parties purportedly got the memo earlier in the week. From a credible source via e-mail:

Good friend passed on a note from a hedge-funder who thinks the S&P not only fudged its figures for today’s downgrade, but leaked it in-advance earlier this week to a few hedge fund insiders who made a killing off it. That would square with the fake “states face bankruptcy” panic scam earlier this year, which made a few people a lot of fast money.

I assume they did not make a directional bet but went long vol.

So what if bond yields go up 50 basis points on Monday, which is normally a monster move? It just puts us back to where we were last Monday.

So why didn’t investors dump Treasuries with this threat hanging over the market’s head? Maybe investors have wised up and realize the ratings are worthless (more on that shortly).

Yves goes on to explain a bigger, stinkier aspect to the downgrade.  It’s politics and a possible we’ll-help-Republicans-if-they-protect-us deal between Republicans and S&P.

Jane Hamsher highlights the hypocrisy of the S&P rating, since it shifted from its 2010 rationale of demographic stress to a February 2011 focus on entitlements. And it didn’t bat an eye at the $2.6 trillion deficit-increasing Bush tax cut extension at year end 2010. More from Hamsher:

Neither Moody’s nor Fitch downgraded US debt at this time. And S&P can’t quite come up with a consistent answer about why they are out there by themselves. It’s like they looked at a public opinion poll, decided that there was no way anyone would argue with “partisan bickering” as a justification, and crossed their fingers that nobody would actually question what it is that they were justifying.

S&P is playing footsie with the Republicans, who are passing bills to relieve them of the legal liabilities that Dodd-Frank exposes them to — even as the SEC is investigating S&P for fraud in the mortgage meltdown.

Some said that S&P wouldn’t dare downgrade the US debt. But it was all over four days ago when Pimco’s Mohammed El-Erian said that S&P was “under pressure” on the US rating.

If you didn’t happen to catch Devan Sharma’s testimony before the House Financial Services Committee last week, this was what he said:

As Dodd-Frank rulemaking progresses, we believe it is critical that new regulations preserve the ability of NRSROs to make their own analytical decisions without fear that those decisions will be later second-guessed if the future does not turn out to be as anticipate or that in publishing a potential controversial view, they will expose themselves to regulatory retaliation.

Pressures of that sort could only undermine the significant progress we believe has been made over the years by rating agencies and regulators alike to provide the market with transparent, quality and generally independent views about the credit-worthiness of issuers and their securities. I thank you for the opportunity to participate in the hearing and I would be happy to answer any questions you may have.

“Pressure.”

That’s what Rep. Randy Neugebauer, chairman of the House Financial Services Subcommittee said on April 29, when he requested documents from the administration: Treasury officials “may have exerted too much pressure on S&P.” The Republicans were already laying the tracks for S&P’s defense in April.

Here are a few more dots to connect the timeline:

April 18: Mitt Romney: “The Obama presidency was downgraded today.”
April 20: Mitt Romney: “Standard & Poor’s, one of the rating agencies, just downgraded their view of the future for America…If you will, they downgraded the Obama presidency.”
July 15: WSJ — “The Obama downgrade.”

They’ve been cooking this one for a while. S&P will defend themselves from the accusation of overt partisan manipulation by claiming the Treasury “pressured” them not to downgrade US debt. The media will focus on what Geithner did or didn’t say during his meetings with S&P in March and April. Nobody will ask about the ridiculous excuses S&P has made for the downgrades, or the fact that they are trying to wreck the American economy just as they did the British economy by playing God with their austerity prescriptions.

People are focused on the market implications of the downgrade, but that isn’t what this is about. It’s about a President who will now be relentlessly tagged with responsibility for a rating given by a disgraced organization whose victims should have liquidated them long ago.

As Politico reported, White House officials feared a downgrade more than they feared default.

This stinks.  I have only quoted the a small part of this story.  I urge readers to go to nakedCapitalism and read the whole article.  This whole downgrade by S&P is politics.  S&P is being used (quite enthusiastically with their cooperation) by bankers and politicians who desire to dismantle the social democratic state.

 

 

 

S and P: Not the Best Judge of Credit-Worthiness

The media and the talking heads will no doubt make a big deal about S&P downgrading the U.S. debt from AAA to AA and threatening to go to A in 6 months.  But it’s really nonsense. The U.S. it is not possible for a sovereign nation with it’s own currency, it’s own central bank, and that borrows in that same currency to go into default.  I just heard Faux Fox News say this afternoon that this will cause all of us to pay higher interest rates on home mortgages and car loans!  Honestly, where do they get these people?  Fox claimed that your car loan and mortgage are “pegged” to the 10 year government bond rate.  Nope.  Not true.

Anyway, what we should be doing is taking another look at this whole bond-ratings scam.  Standard & Poor’s basically has a business model where they rate bond issues in return for fees paid by the banks selling those bonds.  There’s no reason or need for them to rate government issues except maybe for obscure municipal bonds where the information for an informed decision isn’t easy to come by.

So let’s recap how S&P has done in the past.  My favorite two highlights are Japan and Lehman Brothers.  In Japan, this is how interest rates (yields) on 10 year Japanese bonds have behaved since Jan. 2000:

It was in January 2001, right about when the yield hit it’s peak of 2.0% that S&P downgraded Japanese 10 year bonds indicating S&P thought the bonds were riskier and should pay an interest rate premium.  Kind of looks like Mr. Market and Ms. Investors didn’t agree.  Not having learned their lesson on the economics of sovereign debt, S&P did it again in January  2011 with another downgrade.  I think S&P needs to throw out their models and go back to school.

Now let’s look at the other side.  In September 2008, the day before Lehman Brothers filed for bankruptcy, S&P rated them “A”.  Two weeks later, even though Lehman had already gone bankrupt, S&P still didn’t get it and defended their rating:

“In our view, Lehman had a strong franchise across its core investment banking, trading, and investment management business,” S&P stated. “It had adequate liquidity relative to reasonably severe and foreseeable temporary stresses.”

Source: CFO Magazine

 

 

 

 

 

 

 

 

 

 

 

U.S. Government Debt Downgraded by S&P. What a Farce. And Non-Issue.

Yesterday after the U.S. markets closed, Standard & Poor’s downgraded their credit rating on U.S. government bonds.  Previously, the U.S. government had enjoyed for over 70 years the highest possible rating:  AAA.  Now it is “only” going to be AA+.  We should note that the other two major bond-ratings agencies, Moody’s and Fitch’s still rate U.S. debt as AAA.  So what does this mean?  Does it reflect poorly on the U.S.?  Not really. It’s all a farce and it reflects poorly on Standard & Poor’s.

There are many reports in the news, especially in local newspapers and by non-economics reporters, to the effect that this downgrade means higher interest rates.  Some have even suggested that everyone in the U.S. including individuals and corporations and states will pay higher interest rates.  That’s all nonsense.  Not only is a national government not like a household or firm, but bond ratings for governments don’t work like credit ratings for individuals. If you credit score as an individual (those things called FICO scores), then when your credit rating is downgraded you pay higher interest rates for car loans, mortgages, and credit cards.  When governments get downgraded, especially from AAA to only AA+, it doesn’t directly affect interest rates.  Government debt interest rates aren’t really “set” by anybody.  Government debt interest rates are the result of market auctions of the bonds.  If demand for the bonds increases, then prices rise.  In bonds, prices are the inverse of the yield, or interest rate.  When prices go up, then interest rates have effectively gone down.

Lately U.S. Treasury yields (interest rates) have been dropping.  They’ve been dropping regardless of whether you compare now to 3 months ago or just 2 weeks ago.  They’ve been dropping regardless of which maturity (3 month, 6 mo, 2, 5, 10,or 30 year) you look at.  This means that bond prices have been rising. That means there is more demand for U.S. Treasuries.  Not exactly the story of default and risk that S&P maintains, right?  Right.

U.S. Treasury Yields

Maturity Last
Yield
Previous
Yield
3 Month 0.01% 0.01%
2 Year 0.22% 0.25%
5 Year 1.25% 1.13%
10 Year 2.56% 2.46%
30 Year 3.82% 3.72%
Data as of Aug 5 via http://money.cnn.com/data/bonds
So what does this really mean?  The best, clearest, most direct answers I’ve seen are from Wall Street Journal blogger Mark Gongloff.  Here are some of his answers to questions:

Q:What’s the difference between AAA and AA+? That doesn’t sound so bad.

A: It’s not so bad — and there’s not much difference. Technically, AA+ is considered “high grade” credit, while AAA is “prime.” The likelihood of getting paid back by a AA+ credit is considered “very strong,” while a AAA credit’s likelihood of paying you back is “extremely strong.” See the difference? Me neither.

And the U.S. is a special case, given its status as the world’s largest economy and printer of the world’s reserve currency. If your personal credit score falls, then you will almost certainly have to pay more to borrow. The U.S. can get away with a slight credit-rating downgrade without having to pay more to borrow. In fact, many other large, developed economies, including Japan, Canada and Australia, have lost AAA ratings in the past and not had to pay more to borrow in the long run.

Q:Luxembourg is rated AAA. Is the U.S. really a worse credit risk than Luxembourg?

A: No way. Luxembourg is a great country and a perfectly sound credit risk, but it lacks many of the advantages of the U.S., including the aforementioned economy and reserve currency, along with a very large printing press for that currency. If anything, this downgrade exposes some of the other discrepancies in ratings around the world. Should bonds issued by the European Financial Stability Facility, the entity set up to help bail out European sovereigns, really have a AAA credit rating, for example?

Q:Won’t some investors be forced to sell because of even this small downgrade?

A: Maybe, but not very many. Given the liquidity and relative safety of Treasurys, many regulators and money managers put Treasurys in a special category apart from rating considerations. Other managers are considering tweaking their rules to allow them to keep Treasurys.

U.S. banking regulators have confirmed that the downgrade will not force banks, which have big Treasury holdings, to raise any more capital as a cushion against losses. Short-term Treasury ratings weren’t affected, so money-market funds won’t have to sell

Q:What about foreign investors? Surely they’ll sell.

A: Probably, but they may not sell much. They’ve been trying to diversify their holdings for years, but they keep running up against an impregnable hurdle: They’ve got nowhere else to go. For better or worse, Treasurys are the largest fixed-income asset class in the world, by far, and the likelihood of default is next to nothing. The dollar is, for now at least, the world’s reserve currency, meaning foreign central banks will have to keep buying Treasurys. There’s really no other alternative available.

Q:What is the likely effect on interest rates, then?

A: Very hard to say, given all the cross-currents affecting markets right now. In a perverse sense, this downgrade has come at just about the best possible time for the U.S., despite the turmoil in the markets and anxiety about the economy. Those very uncertainties have driven investors around the world — including foreign central banks — to the safety of U.S. Treasurys, pushing U.S. borrowing costs to nearly their lowest levels in generations. So any increase in rates will come off a very low base. If interest rates rise half a percentage point, for example, that might put 10-year Treasury yields at 3% — still an extraordinarily low rate.

What’s more, the market has been bracing for this downgrade for a while, particularly on Friday, when rumors of it were widespread. It’s possible that most of the increase in yields has already happened. In any event, the history of Japan, et al, suggests that a downgrade might have no long-term impact on borrowing costs at all. Investors will likely respond more to inflation pressures, the direction of short-term interest rates and economic growth than to what one or more rating agencies say.

Remember that S&P are the same folks that told us that bonds backed by sub-prime mortgages were AAA a few years ago.  They are the same people that rated Lehman Brothers debt as “A” the night before Lehman declared bankruptcy. They are the same people that downgraded Japan over 10 years ago and yet Japan still pays lower interest rates on government debt than the U.S. despite having a debt-to-GDP ratio of over 200%, more than twice the U.S.  S&P has no special knowledge of the U.S.’s financial position that you don’t have access to.  They get all their data from the news too.

I really do not expect much direct impact from S&P’s decision on financial markets.  It may cause some temporary churn and increase volatility as a few funds might find they are legally required to sell because they must legally only own AAA bonds, but event that’s not likely.  I’m not alone in my prediction here either. Yves Smith at NakedCapitalism and others share my view.  Fortunately banks have been told that the rating change will not affect how bank capital requirements are calculated. Quoting the Wall Street Journal:

Late Friday, federal regulators said the downgrade wouldn’t affect risk-based capital requirements for U.S. banks—the cushion banks must hold to protect against losses. The Federal Reserve, Federal Deposit Insurance Corp. and other federal banking regulators said in a statement the lowering “will not change” the risk weights for Treasury securities and other securities issued or guaranteed by the U.S. government or government agencies.

If you believe S&P, then you must believe that Luxembourg and Leichtenstein are more secure, more powerful economies with a brighter future than the United States.

More on What Happens If Debt Ceiling Isn’t Raised

I’ve mentioned in many previous posts that government debt is really not like private debt.  Instead government bonds are more like another type of currency or money.  The key difference between government bonds and paper money is that bonds pay interest and money doesn’t.  That’s about it.  But it’s a key point because government bonds, specifically T-Bills, are actually used like money.  Large corporations and pension funds don’t keep cash (paper money) lying around.  Instead these days they take whatever money they have each day and put it into liquid T-bills to earn just a little interest.

Spencer at Angry Bear offers more analysis on possible outcomes if Congress fails to raise the debt ceiling in a timely manner (emphasis is mine):

If the debt ceiling is not raised at some point the US government will be unable to meet all of its obligations.

I assume that they will make their interest payments and bond redemptions on schedule and the shortfall will be in paying social secutiry, medicare, military and other obligations. This will naturally impact aggregrate demand and generate a significant negative impact on the economy. Given the severe weakness in the economy this shock most likely would tilt the economy into a recession.

This is rather straight forward analysis, but the more severe situation would be the consequences of the government failing to redeem T bonds and/or T bills or failing to make an interest payment of these debt obligations.

Large business and financial institutions do not leave large sums sitting around not earning interest. For the most part firms invest idle balances in T bills. This reached the point long ago where banks introduced sweep accounts where they will go through a firms deposits late in the day and sweep their balance out and invest them in T bills overnight. This is where the risk free instrument comes to play a major role in the financial system and the economy. In many ways the risk free investment of T bills are like the oil in an engine. It provides the buffer or lubrication in the financial system that allow the various moving parts of the economy to move freely and not rub against each other. If the risk free instrument of the T bill is removed from the system there is nothing around of sufficient size to provide the lubrication that the system requires. Thus, if firms no longer have T bills or risk free instruments to invest in there is a danger that the financial system will seize up like an engine without oil. It becomes a question of confidence and we could quickly have a repeat of something like what happened in 2008 after Lehman Brothers went bankrupt and lenders pulled in their horns and refused to lend to otherwise good credits. This is why those claiming that the US defaulting on its debts would not have severe and wide-ranging consequences are completely wrong. It is why some of the largest financial institutions are already starting to take measures to protect themselves against this possibility.