(05/28/09) Has Credit Concern Replaced Risk Appetite in Determining USD's

S&P revised downward the outlook on the UK sovereign credit rating to “negative” from “stable,” suggesting the nation's AAA credit rating is at risk as UK's net government debt may reach 100% of GDP and stay near that level in the medium term. This once again triggered investors' concerns on sovereign defaults, which has been subdued after several debt-laden emerging economies, including Turkey, Latvia, Hungary, and Ukraine were placed on negative watch or downgraded by Moody's and S&P in late 2008.

The news came in a day after IMF's warning that the UK needs to do more to put the public finances on a sustainable path. S&P's statement said that, based on projections of general government deficits in 2009-2013, “even assuming additional fiscal tightening, the net general government debt burden could approach 100% of GDP and remain near that level in the medium term.” The agency said that UK's financial budget last month unveiled rapid deterioration of the country's public finance, and updated estimates of the cumulative potential gross fiscal cost of government support to the banking system has increased to a range of 100B pounds to 145B pounds, or 7% - 10% of 2009 estimated GDP. “Taken together, these factors could, in our opinion, result in a doubling of the general government debt burden to nearly 100% of GDP by 2013. A government debt burden of that level, if sustained, would in Standard & Poor's view be incompatible with a AAA rating.” That said, there's opportunity for S&P to revise the outlook to “stable” again if “fiscal outturns are more benign than we currently anticipate.”

We believe S&P's downward revision on UK's outlook was driven by the government's ignorance to the fiscal problem and the policymakers' failure to speed up the pace of fiscal consolidation.

Is the US the Next Downgrade Candidate?

The change in the UK outlook has spurred speculation as to who the next candidate for a downgrade will be. Being the first large economy to be warned in the current financial crisis, UK's potential loss of top credit rating hinges on its huge debt burden, and the market believes countries with massive fiscal expansion are also in danger. Among the G10 countries, both Japan and the US should have huge debt to GDP ratios. However, Japan has already lost its top rating in the 90’s, so now, the US bears the biggest risk after analysis showed that the world’s largest economy's debt to GDP ratio may surge above 100% in the coming few years, similar to that of the UK.

It's undeniable that fiscal stimulus is necessary as we are currently facing the unprecedented financial and economic crisis. However, the Treasury's $800B fiscal package earlier this year and the planned budget for the coming few years have been heavily criticized. In 2008, US debt was 66% of GDP, but it's expected to increase to exceed 100% of GDP by 2010.

On May 12 and May 21, corresponding comments from David Walker, the former US comptroller general, and Eric Rosengren, president of the Boston Fed, warned about the US deficit condition. In addition, the US status as the dominant reserve currency made it more vulnerable than the pound and the euro to sovereign risk. According to IMF data, as of 4Q08, over 60% of the allocated central bank reserves are held in USD, followed by the euro, which contributed only 26.5%, while the pound contributed only 4%. We are not saying the US will be downgraded, but the issue will be an overhang for investors in US Treasury and USD-dominated assets given the crucial role played by USD.

Impact on FX

Recent price actions in exchange rates show that credit ratings have overtaken risk appetite as the theme driving the currency market. Moreover, it's more about perceived risk for a downgrade, rather than the actual downgrade itself.

The GBP/USD swiftly recovered the three-cent decline after the S&P news and reported gains on that same day, as well as the day after. While it might have been led by upbeat UK retail sales and other data, it indicated that the market has priced in potential downgrades on the US, also reflecting the fact that rating agencies usually announce a downgrade after the worst has been in place. The
S&P 500 Index edged up a mere 0.5%, while Dow Jones Industrial Average hardly changed as risk aversion increased modestly after the Fed revised down economic forecasts and the FOMC minutes revealed some members' preference to expand credit easing. However, the dollar index failed to benefit and plummeted 3.7%. The dollar index fell five days last week, while stock indices dropped four days. The “inline” weakness between the USD and stocks gave the sign that the “risk factor” used to drive the dollar has been replaced by “credit concerns.”

The chart below shows that the sovereign rating theme has gained more traction recently, probably due to deterioration in fiscal positions.

Credit Ratings’ Impact on FX Was Not That Strong in the Past

The chart below shows that Japanese yen surged surprisingly despite the loss of its top rating in 1998! On July 23, Moody's announced that it will put Japan's long-term foreign debt on its watch list. The news triggered a further rally in USD/JPY, and this sounds rational. However, after reaching the then peak of 147.24 on August 11, the currency pair plummeted and kept plunging, although more rating agencies warned of downgrades. The seemingly illogical phenomenon occurred because some other things happened at that time.

Since the mid-90’s, Japan had reduced interest rates aggressively so as to fight against recession. In1995, it cut its policy rate to 0.5%, compared with 5.25% in the US. A huge carry trade opportunity was seen, and thus created the USD/JPY uptrend until late 1998 when the LTCM crisis triggered unwinding of carry trades. In that case, the downgrades had become non-events when compared with the LTCM crisis.