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S&P Downgrade Warning: Goldman Sachs Damage Control Part 2

Tyler Durden's picture




 

For all those who read the initial attempt at damage control from Jan Hatzius over the S&P warning yesterday, this follow up from Goldman's Alec Phillips will come as no surprise. To all those who may have missed the prompt note which came out after Mohamed El-Erian FT oped, the below will still not come as a surprise. Bottom line: "Although the US already appears to be on the edge of AAA territory by rating agency criteria and further deterioration of those measures seems likely, policy credibility is likely to be more important than the level of fiscal ratios at any given time. While enactment of major structural reforms to entitlement programs or the tax code look challenging in the next year, today’s announcement from S&P may on the margin increase the likelihood that Congress enacts one or more fiscal rules along with the increase in the debt limit, which we already viewed as a good possibility. The most likely change would be discretionary spending caps, which could apply for multiple years and would be difficult to undo once put in place. A second possibility is some version of the “failsafe” concept that President Obama proposed last week, which would require automatic reductions in spending and “tax expenditures” if by 2014 the debt to GDP ratio has not yet stabilized and is not projected to decline in the second half of the decade." Of course as those who followed our notes during the S&P conference call, to a rational man, none of the above would come as credible, therefore inevitably pushing the US to an AA handle by 2013. Of course, this little piece of theater is once again very much irrelevant in the grand scheme of things: by 2013 we will have much bigger issues on our hands.

From Goldman Sachs:

Implications of S&P’s Negative Outlook on US Sovereign Debt

Standard and Poor’s has revised its outlook on the long-term rating of US sovereign debt from stable to negative, while reiterating its AAA rating and A-1+ long-term and short-term ratings. The downbeat view appears to be based primarily on S&P’s perception of a lack of urgency regarding fiscal reform and the possibility that medium- to long-term reform might not be addressed and implemented by 2013. While we agree that significant fiscal tightening will be necessary to ensure fiscal sustainability, and while we have also pointed to 2013 as the most likely timing for major reform, we have a somewhat more optimistic view of the US situation over the next few years, due in part to more optimistic economic forecasts, and in part to our assumption that some fiscal tightening is likely to occur even in the absence of a “grand bargain” on fiscal policy.

1. It’s the possibility of a rating change, not the underlying view, that matters. While the S&P action has received a great deal of attention, the main importance of their revised outlook is in the information it holds regarding the potential for a rating change in the future (which they control), rather than their analysis of the underlying fiscal situation (where the views of the ratings agencies are a few among many). In our view, the consensus expectation among market participants is that a broad fiscal agreement encompassing tax and entitlement reforms is unlikely to be reached before the presidential election, but is possible if not likely soon thereafter. In that context, it should not be surprising that S&P would take a more negative view if fiscal reforms are not enacted by 2013—when many market participants appear to expect them.

2. Increased downgrade risk doesn’t necessarily imply increased Treasury yields
. The move to negative outlook put significant pressure on equities today. The S&P declined by nearly 2% shortly after the announcement, though it finished the day down only 1.1%. Not surprisingly the government austerity basket put together by our colleagues in equity research declined by 1.5% on the day, more than the broader market (for discussion of this basket, see for instance “United States: Government Austerity Update,” March 22, 2011). The reaction in the Treasury market was more surprising. Immediately following the announcement, the 10-year Treasury yield rose by around 6bps. However, Treasuries subsequently rallied, with the 10-year finishing the day at a yield 3bps lower. While the modest rally in Treasuries can probably be attributed to a number of factors, potentially including concerns regarding fiscal issues in the European periphery, it is worth noting that: (1) a significant push toward fiscal austerity would lead to lower growth, and (2) lower growth would lead to easier monetary policy for longer. As outlined in more detail in a recent report, fiscal tightening of 1% of GDP has been associated with reduced output of 0.5% within two years, but would also tend to keep short-term policy interest rates lower than they would otherwise have been (see “Will Fiscal Retrenchment Keep the Funds Rate Low?” US Economics Analyst 11/13, April 1, 2011). The effect of a similar tightening in the US would most likely be greater given the smaller boost from trade improvement and the fact that short-term interest rates are already at the zero bound. The upshot is that while most of the commentary around potential ratings changes is likely to focus on the potential increase in yields as compensation for perceived credit risk, the policies that would need to be pursued to avoid a ratings change could push in the opposite direction.

3. The fiscal outlook is indeed problematic, though our outlook is not as negative as S&P’s. We forecast a federal deficit of 4.5% of GDP in 2013 (vs. S&P’s 6% base case and 4.6% optimistic scenario) and a debt to GDP ratio of 74% (vs. S&P’s 84% base case general government figure, and 80% under their optimistic scenario, though these numbers are not directly comparable). In essence, our central forecast is fairly close to S&P’s optimistic scenario. Even in their own optimistic scenario, however, S&P indicates that the US fiscal profile by 2013 would be “less robust than those of other AAA rated sovereigns.”

4. The US compares unfavorably to other AAA nations. Two factors that rating agencies such as S&P and Moody’s use in their analyses are the ratio of net debt to GDP and the ratio of net interest payments to government revenues. In both cases, the ratings typically reflect “general government debt,” a definition which covers all levels of government, including state and local governments in the US, for instance. In the case of the US, most of the net debt—and most of the rating agency concern—is at the federal level. The first exhibit below compares the US to other AAA-rated countries as well as a select group of AA+ to AA- countries for which cross-country data is available. It implies that the US is already at the outer edge of AAA territory.

5. The UK faced a similar situation in 2009 and 2010. On May 21, 2009, S&P revised the outlook for its sovereign outlook on the UK to negative; it reaffirmed its negative outlook on July 12, 2010, despite the announcement of an austerity package. In October 2010, the UK outlook was revised back to stable from negative once the coalition government announced completion of its spending review. While this implies that a reversal in the negative outlook is possible, it also implies that, at least in the US context, a reform package would probably need to be adopted before the outlook would be changed. A second important lesson from the UK episode is that while S&P put its sovereign rating on negative outlook, other agencies acted differently. Moody’s, for instance, declined to change its outlook on its UK rating in 2009 or 2010. In contrast, Moody’s has recently indicated increased concern about the UK fiscal position in part due to slower than expected growth that has been a byproduct of fiscal tightening.

6. Fiscal reform plans aren’t focused entirely on the same criteria as rating agencies. The second exhibit shows the US federal fiscal position on these two metrics, with projections under several scenarios covering 2011 to 2015. Most scenarios would take the US further into risk of a downgrade using the rating agencies’ stated criteria (for instance, Moody’s has in the past indicated that the edge of its “reversibility band” for a downgrade from AAA is an interest to revenue ratio of 14%; the definition and coverage of the measures in the chart may differ somewhat but the implication is similar). Our own budget forecast, which incorporates our relatively optimistic economic outlook as well as some budget-friendly policies (discretionary spending cuts of $25bn in 2011 and another $25bn in 2012, phase down of overseas military operations, and extension of some but not all of the tax cuts set to expire after 2012) indicates that the US could potentially stay out of the fiscal “danger zone” for a few more years. Most official forecasts show greater deterioration of these measures. Interestingly, the highest profile reform proposals, from the co-chairs of the President’s Fiscal Commission, Sen. Alan Simpson (R-WY) and Erskine Bowles (D) and, separately, from Rep. Paul Ryan (R-WI) would result in a much more benign path for the debt/GDP ratio, but would still allow the interest to revenue ratio to increase to levels that the rating agencies would likely view as problematic.

7. The trajectory of fiscal policy is likely to be more important than absolute levels; fiscal rules could play an important role. Although the US already appears to be on the edge of AAA territory by rating agency criteria and further deterioration of those measures seems likely, policy credibility is likely to be more important than the level of fiscal ratios at any given time. While enactment of major structural reforms to entitlement programs or the tax code look challenging in the next year, today’s announcement from S&P may on the margin increase the likelihood that Congress enacts one or more fiscal rules along with the increase in the debt limit, which we already viewed as a good possibility. The most likely change would be discretionary spending caps, which could apply for multiple years and would be difficult to undo once put in place. A second possibility is some version of the “failsafe” concept that President Obama proposed last week, which would require automatic reductions in spending and “tax expenditures” if by 2014 the debt to GDP ratio has not yet stabilized and is not projected to decline in the second half of the decade (see “The President’s Fiscal Proposals and the Current State of the Fiscal Debate,” US Daily, April 14, 2011).

8. Congress will soon face additional fiscal tests. Congress is on recess through May 2. When it returns, the focus will be on the ongoing debate over the FY2012 budget, and the debt limit. On the former, the focus will be on two issues: first, the Senate Budget Committee may release its own budget resolution (the House passed its resolution last week). It is likely to propose expiration of some tax policies (i.e., revenue increases) and some structural reforms (i.e., spending cuts). Second, there is a possibility that an agreement could emerge from the bipartisan group in the Senate known as the “Gang of Six,” which has been working to develop legislation along the lines of the recommendations of the president’s fiscal commission. If the group can reach agreement, it is likely at some point in May as well. The debt limit will be a separate debate, which is not likely to start in earnest until the Treasury reaches the debt limit on May 16. At that point, the Treasury can redeem debt in certain federal retirement funds and use other accounting strategies to remain at the limit without breaching it, buying another 6 to 8 weeks worth of debt issuance capacity. We assume that Congress will act to raise the limit at some point between May 16 and July 8, when the Treasury expects the debt limit to become binding (for more detail, see “Q&A on the Fiscal Debate, US Economics Analyst 11/14, April 8, 2010).

 

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Tue, 04/19/2011 - 07:13 | 1183222 writingsonthewall
writingsonthewall's picture

No seriously now - stop messing about.

Fuck Goldman Sachs - who the fuck do they think they are?

Tue, 04/19/2011 - 07:26 | 1183241 Troll Magnet
Troll Magnet's picture

blaspheme!  they're doing god's work, you know?

Tue, 04/19/2011 - 08:42 | 1183395 writingsonthewall
writingsonthewall's picture

That cue ball blankenfiend needs a good beating. Where is divine intervention when you need it?

Tue, 04/19/2011 - 10:34 | 1183791 rocker
rocker's picture

But, but, but, but.......Isn't he God's angel...........He told me so.

Tue, 04/19/2011 - 07:21 | 1183231 spiral_eyes
spiral_eyes's picture

we're simmering along nicely through default by debasement, to china pulling out of treasuries, the fed stepping in as monetizer of last resort, full hyperinflation, the death of the dollar and a new world order.

Tue, 04/19/2011 - 07:21 | 1183235 ZeroPower
ZeroPower's picture

GS Damage Control - a nice preemptive move for their eoy 2011 S&P target downgrades. Soon...

Tue, 04/19/2011 - 07:38 | 1183262 Re-Discovery
Re-Discovery's picture

-1

See link below.  Just re-naming it.

Tue, 04/19/2011 - 07:27 | 1183242 TexDenim
TexDenim's picture

The point of S&P is that newspaper readers in Peoria are now aware of what GS and the rest of us have known since QE2 began. It's a question of news management, not financial management. Not surprised that El Erian and GS are running their printing presses overtime.

Tue, 04/19/2011 - 09:19 | 1183322 knukles
knukles's picture

"Not surprised that El Erian and GS are running their printing presses overtime."

The lawyer in the financial mystery novel intones; "Your honor, we have signed confessions from the parties of collusion, misuse of confidential material non-public inside information, front running, breach of commercial best effort fiduciary standards, fraud, grand larceny and misrepresentation. 

Tue, 04/19/2011 - 07:28 | 1183244 Forgiven
Forgiven's picture

Really piss them all off.  Buy Silver.

Tue, 04/19/2011 - 07:33 | 1183251 Bubbles...bubbl...
Bubbles...bubbles everywhere's picture

Great! They are comparing us to the UK. We are truly fucked.

Tue, 04/19/2011 - 07:36 | 1183259 sangell
sangell's picture

Average maturity on British government debt is 14 years... they've locked in their interest expense ours has no where to go but up!

Tue, 04/19/2011 - 07:42 | 1183265 Bubbles...bubbl...
Bubbles...bubbles everywhere's picture

If you ever lived in the UK, you would now what I mean.

On the other hand, it's very comforting to know we fall somewhere between soon-to-be-wiped-out Israel, insolvent Spain and radioactive wasteland Japan. Good company indeed. 

Tue, 04/19/2011 - 08:14 | 1183324 knukles
knukles's picture

LOL.  Soooooo spot on.

Tue, 04/19/2011 - 09:11 | 1183468 citrine
citrine's picture

Well said!

Tue, 04/19/2011 - 07:31 | 1183252 Re-Discovery
Re-Discovery's picture

http://www.bloomberg.com/news/2011-04-19/bernanke-may-reinvest-maturing-debt-to-avoid-cold-turkey-end-to-stimulus.html

QE/CD (Currency Devaluation) Infinity confirmed.  Rickards nailed this, but as TD established, it won't nearly be enough. The Fed is scared to death, and so we all should be.

Tue, 04/19/2011 - 07:44 | 1183267 Catullus
Catullus's picture

QE-2 lite

Tue, 04/19/2011 - 07:33 | 1183256 sangell
sangell's picture

Obama should have done what Reagan did. Take the pain in the first years of your term and get beaten up in the midterm election but by the time you are running for re-election the economy will, hopefully, be improving and people will give you credit for doing what needed to be done.

Tue, 04/19/2011 - 08:16 | 1183329 moneymutt
moneymutt's picture

oh please, the econ improved for Reagan because the policies implemented by Volcker at end of Carter years, which hurt Carter immensely, finally yielded good results by end of Reagans first term. Everyone knew higher interest rates wold hurt for several years, but then inflation beat back and economy recovered. Pres have little short term power over economy. Bush 1 and Clinton did put us on track for surplus budget, rather than defecits because they raised taxes but even the good long term trend was quickly reversed in just a few years of W admin and of course a bit of a recession at beginning of 2000. Prez and Congress can effect budget, but general economic cross slower cycle over which only Fed has powerful control

Tue, 04/19/2011 - 08:19 | 1183330 Chuck Walla
Chuck Walla's picture

!. Obama is just not made that way. Nor was he educated that way. He is conversant in only one political/economic theory and his "new" ideas are rooted in 150 year old philosophy. He simply does not know anything else.

 

2. Votes cost a lot of money when your party is a one note samba. Rich bad, poverty good(unless you're in the club, of course). Daddy take care of you just call you're Ol' Uncle Sugar. He be payin' while you be layin'.

 

3. Soros didn't pay for a thinker, he paid big for a tool.

 

To conclude: Sugar Daddy politics and freedom are mutually exclusive.

Tue, 04/19/2011 - 07:41 | 1183264 TruthInSunshine
TruthInSunshine's picture

US Banks Reporting Phantom Income on $1.4 Trillion Delinquent Mortgages

I posted this link a few times to demonstrate one thing - 3 years ago, this would be thought impossible.  Now, it's probably only slightly surprising to most. And this tells us that we are in bizzaro land, no? How else would one explain the ability of major banks to legally report non-payment of loans as payment of loans?

Okay...on to the broader topic.

IMO, throw all ratings issues, central bank intervention, consumer sentiment, blah blah blah aside.

Deleveraging is the one key theme that will continue. Governments will continue to leverage up, whether by repairing bridges, painting over grafitti, buying fighter jets - whatever - and it will all be like pissing into a strong wind as consumers, who drive roughly 70% of all economic activity, continue to deleverage.

Bernanke is finding out that he is not the wizard some think he is, in trying to trump the natural market laws of supply/demand based on price. He found he could temporarily skew/offset the markets full impact, but that to do so at the margin and even temporarily required an incredible expenditure of resources and ammunition that only came back or is in the process of coming back to wreak havoc, as market distortions create future tsunamis (sometimes with nuclear/radiological consequences).

Tue, 04/19/2011 - 07:56 | 1183284 mendigo
mendigo's picture

in short - these guys are dependant on qe to prop-up the markets

they will be just as dependant (likely more so) in 2013

Tue, 04/19/2011 - 07:56 | 1183286 gordengeko
gordengeko's picture

..."by 2013 we will have much bigger issues on our hands."

What exactly are you getting at there TD??:)

(Seti finds massive alien fleet heading towards earth)

http://www.youtube.com/watch?v=Yiau7DypQi0

Tue, 04/19/2011 - 08:04 | 1183298 TruthInSunshine
TruthInSunshine's picture

First laugh I've had in at least a day.

Thanks.

Tue, 04/19/2011 - 08:28 | 1183368 DavidC
DavidC's picture

What policy credibility ?! There isn't ANY!

DavidC

Tue, 04/19/2011 - 09:06 | 1183454 Commander Cody
Commander Cody's picture

Most of the talk on MSM regarding fiscal deficit reduction is focused on entitlements.  Will no one bring up the large impact on the deficit that eliminating subsidies to industry will achieve?  I guess that's a non-starter for the fascists in control.  How about a fair tax code?  That will, most likely, mean higher rates and fewer deductions for the middle class while additional loopholes will be created for the wealthy.  Its only a matter of time when I will be completely off the grid.  Wish you all well.

Tue, 04/19/2011 - 09:47 | 1183558 Urban Redneck
Urban Redneck's picture

"failsafe"

"lock box"

"debt ceiling"

GS = BS

Tue, 04/19/2011 - 10:46 | 1183855 TwoShortPlanks
TwoShortPlanks's picture

Treasury is using S&P downgrade to whip Congress into a Yes, that's all. It's been fabricated...yet still real at the same time...how does that work?!

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