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The Great Debate

El-Erian on the S&P’s negative outlook for US debt

By Reuters Staff
April 18, 2011

JEN ROGERS, REUTERS INSIDER: S&P sending a shock through the markets after the credit rating agency cut its long term outlook for the US to negative from stable saying it believes there’s a risk US policymakers may not reach an agreement on how to address the country’s long term fiscal pressures. PIMCO has also had serious concerns about the US fiscal outlook, shifting to a short position in US government-related debt in March. PIMCO’s CEO Mohamed El-Erian joins us now. So Mohamed, can you help us make sense of the bond market reaction to this news. Treasuries by and large now higher on the day; equities seem to be the one’s taking it on the chin. What do you make of this?

MOHAMED EL-ERIAN, PIMCO: So on the treasury market, you’re seeing a steepening; you’re seeing the front end doing better and the long end doing relatively worse. And the reason for this is simple: people now recognize that you’re gonna have to have some sort of fiscal tightening which means that the outlook for growth is less bright than it was before the announcement and therefore, short term treasuries are gaining. However, long term treasuries which reflect the fiscal risk premium are doing less well. As regards to other assets, it’s very simple. You cannot be a good house in a deteriorating neighborhood. So, be it equities, be it credit, they’re all being hit because people are realizing that the neighborhood itself is deteriorating.

ROGERS: You have been outspoken on the US before. A lot of people seem to be caught a little bit off guard by this news. Surprised- were you surprised?

EL-ERIAN: We weren’t surprised, a couple of qualifications. One is, we have our own internal ratings. So, when we look at S&P and when we look at Moody’s; it’s more for what it says to the rest of the world. As you know, we have been concerned for a while now about the need for the US to take more seriously its fiscal issues. Having said that, we must never forget that these rating agencies play a very important role in the industry. A lot of people invest on the basis of these ratings and therefore, you’re seeing, in our view, a delayed reaction to the reality which is that the US needs to get its fiscal house in order.

ROGERS: Under your internal rating, is the US no longer AAA?

EL-ERIAN: The US risks losing its AAA on our internal ratings.

ROGERS: But it still maintains a AAA?

EL-ERIAN: Yeah, I mean, whether it’s AAA or AA is right at the edge right now and that’s why you’ve heard us over and over again say it’s very important for the US to control its fiscal destiny. The US doesn’t want to be in a position where it loses AAA.

ROGERS: So what would it take in your internal ratings for it to tip?

EL-ERIAN: If we see delayed, further delays in agreeing to a medium term reform program and in our view, it has to have both a revenue component and an expenditure component. So, further delays to agreement on a medium term reform program would be detrimental to the ratings. And let’s not forget that that impacts every single American. If—and it’s still an if—but if the US were to lose its AAA, borrowing costs would go up for everybody, the Dollar would be weaker and the willingness of the rest of the world to hold our assets would go down. So, everybody would be worse off with a downgrade of the US rating.

ROGERS: So that would be the chain reaction. And what do you think the odds are that could take us there? S&P is saying a one in three chance of a downgrade within two years. Do you think the chances are even higher?

EL-ERIAN: Yeah. S&P says one in three, we would put it slightly higher.  The good news is it seems that Washington is waking up. So we’ve had two plans put on the table. One by the Republicans, one by President Obama and hopefully you’re gonna get convergence toward this. And we have a catalyst. The debate on the debt ceiling can provide an important catalyst. The clear signal to Washington DC today is please get your fiscal house in order, otherwise, every segment of US society will be worse off.

ROGERS: When you say slightly higher, can you help me out there at all? Do you think it’s one in two chance?

EL-ERIAN: Yeah, I will put it at one in two.

ROGERS: S&P is giving the US until the end of 2013 to show meaningful progress. Is that enough time?

EL-ERIAN: It’s enough time to get agreement on a medium term reform program. So, what’s critical is that the time dimension is important. The US doesn’t have an immediate fiscal issue, it has a medium term fiscal issue and therefore, you need a medium term package. It’s critical that you get agreement quickly on the medium term because the medium term has a way of creeping up on you. So, they’re right by saying by 2013 the US has time to get its fiscal house in order, but it cannot delay the formulation of these measures. Remember, there are three steps to any credible adjustment. The first one is formulating your action plan. The second one is implementing your action plan. And the third one is putting in place whatever corrective mid-course adjustments you need. We haven’t even seen the first step in the case of the US.

ROGERS: Do you think that we will get closer to the first step with this news out of S&P or does it hinder us in any way, getting a credible budget deal just because this comes against a backdrop that is very highly politicized right now in DC?

EL-ERIAN: Hopefully it will help. I think that there are messages going to Washington from all quarters that this is a serious issue and that no one can escape the implication of a further deterioration in the US fiscal situation.  And it’s not just about the US, it’s also about the global economy. The US is at the core of the global economy. It provides the reserve currency. It provides the deepest and most liquid financial markets. And it provides a AAA of AAA. So the global system has an interest in the US getting its act together.

ROGERS: If this indeed then acts as catalyst for Washington to get its act together, could it in fact be bullish for treasuries?

EL-ERIAN: Over the long term, it could be bullish for treasuries and that’s something that we keep an eye on. Over the short term, there’s gonna be all sorts of countervailing forces on the treasury market because, don’t forget, there’s something else big there- the big elephant in the room. The main buyers of treasury, the Federal Reserve, will stop buying at the end of June and the Federal Reserve has been taking over 70% of new treasury issuance. So your main buyer is stepping out so there are other issues that are also influencing the outlook for the treasury market.

ROGERS: To take the other side of this, I mean if this is the nail on the coffin for the 30-year bull market in bonds perhaps, how do you position the Total Return Fund to benefit particularly against the five months of outflows that we’ve seen?

EL-ERIAN: So a few principles are really important. First, the fixed-income market is a global fixed-income market. And there are government bonds all over the world including from countries whose credit standing is improving rather than deteriorating. Second, the fixed-income market is much more than just government bonds. There are many other segments out there that provide value.  And thirdly, the concept that Bill Gross came up with, which is concept of safe spread, be open-minded as to how you define safe spread. Don’t define it in the old fashion way which is US treasury; look at opportunities all over the world—what my colleague Tony Crescenzi calls a supermarket of global fixed-income—and that is how we’ve been positioning all our products is to recognize that this is a global world with global risks but also global opportunities.

ROGERS: Are we running the risk of making too big a deal out of this?  After all it’s just one in three chance that a downgrade coming, we’re not talking about a default, we run the printing presses still. I mean is this something that we should just let run off our back here today?

EL-ERIAN: I wouldn’t let it run off our back even though we control the printing press. What we mean when we say we control the printing press is since we have issued our debt in Dollars and since we can print in Dollars the chance of a default are low. That is absolutely correct but there is no free lunch here. If we go off and start monetizing even more of our debt, it will weaken the Dollar, and importantly it will erode the standing of the US in the global system. Remember, the rest of the world holds a lot of US financial assets because we are the reserve currency. So we don’t want to abuse that privilege that we have because, if we abuse it for too long, we could end up losing it.

ROGERS: I was just talking with somebody at S&P- David Beers, the Global Head of Sovereign Ratings at S&P. I mean they seem to be taking a little bit of heat on this. People saying they’re being too aggressive here, questioning their credibility. Do you have any thoughts on that?

EL-ERIAN: No, I think in general actually the rating agencies have tended to be too late. I mean look what’s happening in Europe; that’s a perfect example where the rating agencies woke up too late to the deterioration in sovereign credit standing. And now, they’ve been playing catch-up; overnight we caught yet another round of downgrades this time of Irish banks. So, my impression is that the rating agencies tend to be hesitant in the beginning and we’ve seen that especially in the sovereign world. And I think they are only catching up to the reality which is that we’ve seen a generalized deterioration in the standing of sovereign credit in most advanced economies.

ROGERS: So are US treasuries still something in your opinion that you don’t want to be in right now?

EL-ERIAN: Not at these level of yields. There are other attractive opportunities. I keep on telling people when you hold something in your portfolio, hold it because there’s value, not because it has a label on it, because ultimately you get paid for value. You don’t get paid for a label. And therefore, at this level of yields, we think there are better opportunities in this global market.

ROGERS: And finally before I let you go, you talked about the US sort of being on this precipice between AA and AAA on your internal ratings. And we talked about something that could push it to AA but what could make it go to AAA in a more secure way? Is there something that could happen in Washington that could convince you that it should be steadily in AAA?

EL-ERIAN: There’s absolutely something. The US is a very resilient and strong economy. The weakness right now is in the government sector. Why? Because the government’s balance sheet was used to offset the deleveraging that was occurring in the fourth quarter of 2008. So now, the multinationals have recovered and they’re doing very well, households are slowly recovering, we’ve got to focus on the US public balance sheet. If we were to see actions taken over the medium term- and I stress this over the medium term- if we were to see actions taken over the medium to strengthen that balance sheet, then the US would be a strong AAA.

ROGERS: All right, Mohamed El-Erian from PIMCO, thank you so much for joining us from Newport Beach, California. Appreciate your time. I’m Jen Rogers. This is Reuters Insider.

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