Monday, 25 February 2013

Moody’s pounds sterling - implications of the UK's downgrade

  • The immediate implications of the UK’s downgrade of its long term credit rating are fairly benign 
  • The resulting weakness of the pound will be hailed by some as a boon to the export sector, certainly it will be a boon to the FTSE’s overseas earnings 
  • The more troubling aspect is that it further diminishes the Bank of England’s credibility as a champion of price stability 
  • The demand for gilts will remain structural and ratings-agnostic 
  • Private sector demand for gilts has been weak due to low yields and improving international economic news 
  • More broadly the secular demand for fixed interest assets may be diminishing 

Chart 1: The Triple A Club of countries commanding top ratings from Moody's and Standard & Poor's

Source: Moody's, S&P, Brewin Dolphin
First the sour grapes…

So Moody’s became the first institution to cast doubt on the UK’s ability to maintain its debt. Not much doubt admittedly as we shall discuss. There was a certain inevitability about this decision. When asked, as we frequently were, about the chances of a UK downgrade we tended to describe it as 50/50. Clearly the UK’s fiscal position is weak but, relative to the criteria Moody’s use to judge countries, they ought to conclude that default is more or less impossible.

The best (although by no means flawless) proxy for default risk is the CDS price as it allows investors to profit by their intuition and analysis of the likelihood of default. That probability remains extremely low: it costs just 48 basis points to insure British debt against default. That, it could be argued, is consistent with a downgrade from completely safe to very safe. According to Moody’s the UK has ceased showing:

“Exceptional economic, financial and institutional strengths resulting in unquestioned access to finance.”

Instead it now has:

“Very high economic, institutional or government financial strength and no material medium-term repayment concern.”
The UK continues to command similar insurance costs to those of other triple A countries. In fact based on that measure, a case could be made that only Sweden and Norway truly deserve the triple A rating. Denmark and Finland would be on the cusp of that group - a ringing endorsement of the Scandinavian economic model. Finland, however, is of course distinct in that it is a member of the euro. That means that in many investors eyes its debt should be considered to be denominated in ‘foreign currency’ because money can’t be printed to service debt.

Most eurozone countries are therefore institutionally weaker in terms of their ability to service debt than countries such as the UK but those such as Finland are excused the wrath of the market because, if they were to leave the eurozone, their new currency would be expected to appreciate relative to that of the euros in which its bonds are denominated.

The other interesting sovereign is the US which joins the UK in ratings agency purgatory – triple A in some opinions not in others. The US has tangibly higher potential to default because the executive (the White House) which borrows and spends the Federal money is separated from the legislature (Congress) which gives it the permission to do so. With a political system that deliberately weakens the power of the presidency, there are frequently situations in which the political success of Congress depends upon the political failure of the White House. That creates a worrying incentive for the country to default – even while its access to funds is un-impaired.

Market impact Gilts weakened when they reopened after the news but they have been in a weak trend anyway and with risk assets in demand there is minimal lasting impact from the downgrade.

Chart 2: The real returns on gilts have been uninspiring for a long time...

Source: National Statistics, DataStream

Most private sector buyers of bonds rely on a top rating from one of the main ratings agencies and so, as in the case of the US which was downgraded by S&P or France which lost the highest rating from both the agencies last year, forced liquidations are unlikely. It is worth noting too that on balance S&P appear to be the more trigger happy agency and so we would not wish to be overly relaxed about the prospect of retaining their patronage.

In general the broader private sector has had no real incentive to buy gilts for at least a year given their depressed yields. Principal sources of buying, the Bank of England and the banking sector are both ratings agnostic - the Bank of England for obvious reasons. Banks relies on their own internal models (utilising such things as CDS spreads) to establish creditworthiness when assessing their regulatory capital requirements.

The pound has fallen against both the dollar and the euro although it has recovered some if its earlier drop; presumably as traders closed sterling shorts and reflecting political chaos stemming from the Italian elections.

Longer term effects

The downgrade is a reasonably benign event. Nobody thought the UK was a paragon of fiscal strength but the broader implications are perhaps worth considering. Retaining the AAA rating was perceived as a benchmark for the success of the coalition and so its loss will be seized upon by the opposition ahead of the Chancellor’s update on progress reducing deficits at next month’s budget.

Furthermore the inflationary impact of the weaker pound is going to provide a credibility headwind for the Bank as it stands ready to run the printing presses once more. All in all, the outcome looks bad for gilts and potentially could become very bad if it dissuades the Bank of England from providing further support. We suspect the Bank will choose to characterise this fall as a one-off change in prices (which will eventually wash out) rather than an inflationary trend and therefore will continue to provide support as needed.

A drop in the ocean?

The story of the great rotation will keep on rolling and while gilts, and quality government bonds in general, are due for a something of a reprieve during the summer months, the case for holding them remains extremely challenging. Having discussed the lack of private sector demand for government bonds, it is also worth noting that public sector demand is questionable too.

Chart 3: International reserve asset growth is slowing...

Source: Brewin Dolphin, Bloomberg
Whilst financial repression, under the guise of regulatory requirements, will continue to encourage the financial sector to hold gilts, and bonds in general will be in demand from defined benefit pensions schemes, other funding for developed market debts is diminishing.

Given all the discussion of currency wars, it is ironic that foreign exchange reserve accumulation, the standard measure of global currency manipulation, is at a relative low.

Much of this, in dollar terms, represents the relative decline of the Chinese current account surplus. This is important as Chinese bond buying has been a key plank of support for the US treasury market. We now see reduced reserve accumulation and have in recent years heard of Chinese efforts to diversify their reserves away from treasuries.

Chart 4: Sources of International Reserve Asset growth...
Source: Brewin Dolphin/Bloomberg

The Japanese stopped accumulating currency reserves altogether as their current account fell into deficit last year. The reversal has not prevented the yen depreciating sharply as we have considered before in these notes.

Switzerland was accumulating reserves as a by-product of their own unsterilised foreign exchange manipulation program although that has now ended.

The gulf states, most notably Saudi Arabia, have been accumulating on the basis of the petrodollars being received due to the prolonged period during which Brent has been sold in excess of $100 bboe.

Reserve growth may be slowing in relative terms but it is still rising in absolute terms, and the rate is increasing. Allied to domestic central bank buying that ought to be enough to bring about the slow unwinding of the bond bull market. Should either of those pillars of support be removed, then it stands to inhibit the low borrowing cost driven recovery.

As the great rotation theme continues to play out we will be monitoring all sources of bond demand closely. It appears that demand from ratings-agnostic central banks, pension funds, exporting nations and financial institutions will temper the sell-off providing a useful backdrop for the equity markets. But it is the investment decisions of these institutions, rather than the ramblings of rating agencies that will determine the pace.

Guy Foster
Head of Portfolio Strategy

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