Ramblings of a Portfolio Manager

Standard & Poors Just Issued a Warning on US Government Debt. What a Great Time to Buy US Government Debt!

Last Monday was a harrowing and confusing day in the US capital markets—a day that demonstrated the perverse, sometimes conflicting, nature of investing in financial assets: assets whose prices are determined not by any particular standardized underlying valuation metric but by the supply and demand dynamics of a wide range of investors, from the Ivory Tower PhD quants down to the trailer park chat-room day traders.

US investors awoke Monday to find the US equity market futures already deep in the red. Once again Europe’s debt woes (particularly Greece) had been thrust into the front of the headlines, with more rhetoric about default and further restructurings amid a tanking economy thanks to austerity measures. Like many, we assumed the day would play out as it had for the entire year—weaker hands would be shaken out of US stocks and into Treasuries in the morning, only for the reverse to happen later in the day when the “smart money” took advantage of what was essentially old news to do some bargain hunting. After all, “every” smart investor know that QE2 will be ending soon, producing an outflow from Treasuries, presumably into the next best alternative, US equities. It wasn’t to be. Late in the morning, before the US markets opened, the futures tanked even more and the news hit the wires that Standard & Poors, that Gold Standard, leading edge credit rating agency, which had given AAA rating status to most of the Credit Default Swaps and esoteric real-estate derivative products that almost sunk the world’s financial markets in 2008, had just put the entire outstanding balance of United States Treasuries (and future issuances) on a “negative” from “stable” outlook. For S&P, it was the first step in a 3 step process toward a full downgrade of US debt from its exalted AAA status, a distinction it has held for nearly 80 years, and signaled that years of profligate spending and mounting debt with nothing but political rhetoric and no solutions to the issue, had finally caught up with the world’s largest economy. The outcrop—if the US did not address its deficit and ballooning debt problem, S&P would most likely downgrade the country’s debt from its AAA status within 2 years.

Of course, the rational investor, trained in Friedman, Keynes, Malkiel and Samuelson, to name a few, expected that the bond market would tank that day and though money might not flow directly from Treasuries to stocks, at least the expectation was that the reaction in the equity markets would be “tame.” In fact, the rational investor, including us, was once again taken aback by the perverse nature of the capital markets of late. Financial instruments have never moved exactly as predicted by the text books and that relationship has broken down over time but seldom do we see a complete 180 turn from what would logically be expected. Last Monday, we saw that with the Dow trading down as much as 240 points on heavy volume, while the longer Treasury maturities, after a brief dip, beginning to climb. Huh? If the US were to lose its AAA status, would not it have to pay higher interest rates and, given the relationship between rates and bond prices, would not bonds sink? One would think so but, as we mentioned, the opposite happened, although stocks did recover some of their initial losses over the course of the day.

What happened? The brain trust of economists are still scratching their heads and fiddling with their models replete with Greek symbols, crunching them on Cray’s latest supercomputer. Meanwhile, the rest of us have cobbled together a more homespun explanation for what happened. First of all, some sort of action by the rating agencies was most likely expected by the bond market (heck if we know what the equity markets were expecting-remember influence of the trailer park day traders) and the one we got was the mildest of the moves S&P could make; in fact, it wasn’t even the step before a downgrade: we still have to go on “credit watch negative” before a downgrade is imminent. Secondly, S&P gave us a 33% chance of a downgrade in 2 years. That’s better than even money and extends beyond the next election when we hope (as we always do) that a more fiscally responsible group of politicians will take office. Thirdly and relatedly, the move was seen as indeed political, with S&P basing its decision more on the gridlock it sees in the current Congress than any deeper economic weakness of structural problem in the economy. Fourth, Moody’s ever the politician itself, quickly reassured the markets (and big brother) that it had no intention of following suit with a negative rating of its own. Finally, many in the markets saw the move as a call to action to the politicians—the proverbial straw that would break the camel’s back of gridlock and rhetoric and get those sound bite hogs in DC focused on the real matter at hand—cutting the deficit and reducing our outstanding debt load. It is interesting to note that the dollar fell on that day, as would initially be expected, but stayed low even as bonds rallied. Anyone think the Fed stepped in under QE2 to mitigate the fallout?

That’s a long-winded explanation of why bonds probably didn’t sell off, but why did the equity markets tank and why did bonds actually end up on the day? The answer here is probably more subtle and complex. Compared to what we said about bond market participants above, equity market players are less thoughtful, more reactive and just don’t do as much homework. To them, the reverse was true—S&P’s warning shot might cause Congress to overreact, following the UK and implementing austerity measures before the economy has fully recovered—maybe even canceling the QE3 through 15 that some expected. In addition, failing a resolution, a full downgrade of the US (2 years out at the least) would affect US corporations as well, raising the cost of their borrowings, which are now at an all time low. That would also serve to put the brakes on the fledgling recovery. Finally, the move was seen as changing Bernanke’s Wednesday Q&A on QE2, from something benign to something more hawkish. All of this would be bad for the economy and bad, ultimately, for corporate earnings and thus stocks. So why did US Treasuries rise on the day? Well, as we all know, when the US (or global) economy is seen as potentially having negative issues, investors “de risk” (someone please explain that term to us and how it is done in an hour on trillions of dollars) and flee to quality; the only perceived quality investment left (barring Switzerland and gold) is, you guessed it, US Treasuries. Gold was up on the day, as was Silver. This phenomenon has been seen many times in other countries—during a debt downgrade, it is equities that take the brunt of the downgrade. The funny thing is, following the news, a spate of strong US corporate earnings came out, pushing the yields (and prices) higher, signaling a stronger economy ahead and negating much of the flight to quality (but Gold and Silver still rose, this time on inflation fears—go figure).

Oh, and our 2 cents (less than 0.01 Swiss Franc now) is that Bernanke now comes out even more dovish than expected on April 27th. What simpler and politically more palatable way to avoid a debt crisis than to continue to deflate our currency, paying back our debt faster with worthless dollars, thus simultaneously stimulating our economy further and collecting more taxes at the same nominal rate and avoiding economic or political repercussions of a tax hike or austerity. Anyone see supply side economics in here anywhere? We think this would successfully avoid a downgrade (a growing economy, shrinking debt and higher taxes would keep the ratings fools at bay despite the devalued currency). QE3, we think, just got more probable so we would avoid the Dollar. We’re still not sure what to do about Treasuries, although we certainly wouldn’t hold them here. We just hope the Chinese don’t start voting with their feet (or Bloombergs to be precise). Welcome to the Bizarro Land of investing.