Citi's head FX guy Steven Englander is barely back to the US, and already is pouring the daily dose of fire and brimstone (much deserved) into a market that after nearly 2.5 years of unprecedented complicity, is about to realize that every escalator action has an equal and opposite express elevator reaction (oh, and those same HFTs that make money in an upward momentum environment, are just as effective at putting a minus sign in front of all their signals, wink wink). Some key soundbites from his just released note on what to expect (spoiler alert: nothing good): "The accelerated timing is a surprise and comes at a point at which global market sentiment is extremely weak, so it seems more likely that the reaction in markets will be negative than positive" ..."there may be concern in FX markets that the EUR AAAs are not solid, given the political and economic issues facing the euro zone and how conditions have worsened since the agencies last commented on ratings"..."a downward shock to markets is likely to be USD positive in the near term. This is hardly USD positive once things settle down, but before they settle down, the short term will likely dominate the long-term"..."The odds are that the week will start with FX investors challenging the SNB and MoF to intervene in size"... most importantly, why Europe is sweating bullets after the last bailout attempt announced from Friday has now gone up in flames and the EFSF is seen as being on edge of functionality: "In terms of FX market impact, the biggest would come from a downgrade of one of the AAA eurozone countries who back the EFSF’s AAA rating. This would mean either dropping the EFSF AAA or increasing the contributions of the remaining AAA."and on the topic of everyone's most favorite Federal Reserve: "A Fed response is likely to emerge only if there is turmoil in markets." And here we were warning anyone who cared to listen that the Fed needs a 25% correction before QE3 comes. Well, you may just get it very soon.
Broad market reaction the key
Investors expected that the US would either be downgraded a bit or avoid a downgrade by a hair, so a small downgrade over a couple of months would not have been a big surprise. Given the concern about the US debt ceiling and long term deficit prospects, a significant downgrade risk was very likely already priced in. US rates have been on a steady downturn, so in the market view the downgrade threat was second order to the deterioration in economic prospects.
(As an aside I am just back from 2 1/2 weeks of travels, primarily abroad, in which the overwhelming focus was on the debt ceiling negotiations and the risks of downgrade/default. There was perplexity about the process and concern that the US was not taking its fiscal issues seriously enough.I did not have the impression that either official or private clients were anticipating a near-term downgrade (I certainly wasn't), but it was certainly on the radar screen as a major risk over coming months. My impression is that foreign clients would not automatically dump Treasuries on a downgrade, if market reaction was not extreme.)
The accelerated timing is a surprise and comes at a point at which global market sentiment is extremely weak, so it seems more likely that the reaction in markets will be negative than positive. The confidence impact in a weak market may be larger than the substantive impact based on the surprise in credit markets..
We would emphasize that the USD reaction against most currencies will probably follow broader market reaction. In particular, as emphasized below, if equity and commodity markets keep sliding globally, the main reaction is likely to cut long positions in equities, EM and commodities. These are mainly funded by short USD, so whether or not the safe-haven status of the USD is impaired over the long term, a downward shock to markets is likely to be USD positive in the near term. This is hardly USD positive once things settle down, but before they settle down, the short term will likely dominate the long-term.
As we discuss below, there may be concern in FX markets that the EUR AAAs are not solid, given the political and economic issues facing the euro zone and how conditions have worsened since the agencies last commented on ratings. Official and private investors instinctively may want to sell USD and buy EUR, but the EUR sovereign issues do not look better because the US’ looks worse, and a global risk-off response would be EUR negative. The key immediate investor worry is that no set of European policymakers is willing to buy sufficient peripheral and quasi-peripheral bonds to narrow spreads, so there is little pushback against the panic on Spain and Italy.
The biggest upside for the EUR would come if the ECB bought Spanish and Italian bonds and that might be enough to generate a global response among risk-correlated currencies, if it was done in sufficient size to convince the investors that contagion was overdone.
More pressure on safe havens
CHF is the only certain safe haven among the remaining G10 countries. Moreover it is the only AAA G10 country that whose currency appreciates on bad news. The other G10 AAAs with independent currencies – Canada, Australia, Sweden and Norway tend to sell off when risk aversion rises. Investors may buy JPY despite its own fiscal situation, but the Japanese are increasingly concerned about appreciation given their structural growth and deficit issues. CHF and JPY intervened in currency or money markets over the last week to weaken their currencies. If they do not intervene again on strength, investors may see them as giving up on intervention because of the magnitude and nature of the forces at play. The odds are that the week will start with FX investors challenging the SNB and MoF to intervene in size.
Reserve managers handed a small diversification gift
The downgrade may increase the desire of reserve managers to diversify out of USD, and if risk sells off, they may be given an opportunity to buy the attractive risk correlated G10 AAAs -- NOK, SEK, CAD, AUD -- at significantly lower levels. In thin markets even modest buying will probably lead to a sharp rally, so there may be more price action than flow.
At the end of the day, the downgrade is unlikely to lead to greatly accelerated changes in USD holdings. Reserve managers buy USD because they do not want their currencies to appreciate rapidly, not because they view Treasuries as attractive investments. Unless they are reconciled to more rapid appreciation, the odds are that they will continue to buy USD assets, however unhappily. In the past when faced by a choice of acute pressure on the USD without reserve manager buying and moderate pressure with reserve manager buying they have always chosen the latter, which is why reserve accumulation tends to be faster when the USD is under pressure. The likelihood is that they will complain about how badly treated they are as investors, a complaint which has some validity, but that they are unwilling to walk away and allow a USD rout.
Similarly, calls for creation of alternative reserve assets miss the point. The problem is that buying any alternative assets means selling the USD now in reserves. The reserves managers would have to find investors willing to hold the USD that they are selling – such selling will generate the USD collapse they have spent the last decade trying to avoid. (As an example consider the possibility that the IMF were able to increase the supply of SDR’s as an alternative reserve asset. Presumably central banks would line up to sell USD against this new asset, but they would have to find someone willing to buy the USD.)
S&P vs. the Treasury
The original S&P downgrade contained a USD2trn calculation error. After correcting they chose to downgrade anyway, focusing on the poor political process and the likelihood that debt to GDP keeps rising beyond the middle of the decade. The S&P error and limited re-examination may serve to diminish slightly the credibility of the downgrade in FX markets. Both the casualness of the S&P mistake and the ease with which US policymakers debated deficit changes of several trillion reinforces the perception that a trillion dollars is not what it used to be.
The S&P downgrade: document:
Why USD2trn here and there does not matter to S&P:
The Treasury strikes back:
What can the Fed do?
A Fed response is likely to emerge only if there is turmoil in markets. On the margin if the downgrade contributes to conditions that support QE3 or other easing measures, the USD is likely to weaken once the measures are announced. In the first instance the fed will probably hope that the market reaction is minimal and that they are not called on to take a position. In my encounters with foreign officials, I find that the response to QE2 (and even more so to QE3 in anticipation) is overwhelmingly negative. If QE3 were implemented it would likely be far more negative for the USD than any direct reaction to the downgrade is likely to be.
Other FX market risks
In terms of FX market impact, the biggest would come from a downgrade of one of the AAA eurozone countries who back the EFSF’s AAA rating. This would mean either dropping the EFSF AAA or increasing the contributions of the remaining AAA. As of Friday close, the only two AAA countries with CDS over 100bps were Austria (101bps) and France (144bps). The US (56bps) was the fourth lowest. France was 37th lowest, with CDS slightly wider than Mexico, Brazil, Thailand and Philippines, and slightly narrower than Indonesia, Peru and South Africa, none of whom are close to AAA. While CDS and credit ratings do not map one to one onto each other, if FX investors come to perceive that rating agencies are taking a more aggressive posture, they may easily come to question the sustainability of the weaker AAAs.