Wall St. downplays downgrade. Will markets listen?

August 6, 2011

Reporting for this post was done by the U.S. markets team in New York.

A number of Wall Street analysts have reacted to the historic downgrade of the U.S. AAA rating on Friday evening with a shrug. Some argue the ratings firm’s warnings about the U.S. debt deal offered an early signal, while others dismissed the action, questioning the company’s record of giving AAA ratings to housing assets that turned out to be toxic.

Vassili Serbriakov, currency strategist at Wells Fargo in New York, said:

It’s not entirely unexpected. I believe it has already been partly priced into the dollar. We expect some further pressure on the U.S. dollar, but a sharp sell-off is in our view unlikely.

Paul Dales, chief U.S. economist at Capital Economics in Toronto:

I don’t think it will mean too much to be honest. There will probably be an initial market wobble — FX markets might struggle and Treasury yields might fall a bit. The bigger picture is really that the world is not much different.

Greg Salvaggio at Tempus Consulting in Washington was more scathing.

I really find it quite amazing that a credit agency that could rate mortgage backed securities AAA has decided to downgrade the U.S. government.

Still, following the worst week for stocks since the financial crisis and with concern still high about Europe’s own debt woes, it is not difficult to envision a turbulent week ahead.

Importantly, investors are bracing for a series of downgrades of other entities like fallen mortgage giants Fannie Mae and Freddie Mac, whose credit strength is directly linked to the U.S. government’s, and certain municipal bonds that are backed by Treasuries.

William Larkin, fixed-income portfolio manager at Cabot Money Management, in Salem, Massachusetts, describes the risks in more detail:

I think we are going to test the system on Monday. One of the problems that everyone is worried about with a downgrade is there is a lot of investment guidelines where you are forced to maintain certain credit quality, and if you are bumping up against it, all of a sudden you are going to fall below your guidelines, so that means you probably have to buy more Treasuries and probably sell corporate debt or something like that. The interesting thing is going to be the impact on the municipal bond market because a lot of municipal bonds have as collateral U.S. Treasury securities. It is a tiny market and it is easily spooked but it is heavily invested in by retail investors. That is going to be the one I am going to be keeping an eye on.

Given that level of uncertainty, it’s hard to see markets reacting with anything but trepidation as they get used to a new world, one where the safety anchor of AAA U.S. Treasuries is no longer the golden benchmark. Curiously, the U.S. bond market might actually rally as riskier assets selloff, pushing already very low bond yields even lower. But this is a privilege the United States could be on its way to losing, particularly if other rating agencies follow S&P’s lead.

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S&P – total disgrace at their apparent actions that ‘unknowingly’ caused the “GFC”. Has anything changed though? Lack of regulation compounded by successive US Gov’s coupled with a greedy side of human nature has undoubtedly lead us here. It seems that finally, and tragically, after years of spinning and weaving done in both Wall Street and Washington, Fund managers and investors may be waking up too early to avoid catching the US economy / “Emperor’s New Clothes” not being as fabulous as had been believed. Let’s hope my US brothers and sisters recognise the Republicans as the enemy within before it’s too late.

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