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