Rating agencies keeping an eye on US proceedings

In this week’s bulletin:

  • The US dominated the headlines as politicians debated the future levels of the US debt ceiling.
  • Ratings agencies were taking a keen eye on proceedings, with speculation rife that political squabbling was doing nothing to help the country’s case ahead of a possible credit downgrade.
  • The eurozone took a backseat for once, though Spain was still the subject of attention as Moody’s warned of the challenges faced going forward.
  • The weak sterling is hindering household income, as the UK currency now stands 20% lower than in 2007.
  • The big five banks in the UK report their results this week, with a mixed bag predicted.


AAA-rated political system?

The week was dominated by the US, as President Barack Obama was forced to issue an 11th-hour appeal for common sense in a bid to end the impasse over the level of theUS debt ceiling. Late on Friday, Mr Obama stated,  “This is not a situation where the two parties are miles apart. There are plenty of ways out of this mess, but we are almost out of time. If we are to lose our AAA rating, it won’t be because the country is incapable of paying the bills, but because we do not have a AAA political system.”

Where we stand on Monday, the world is a more optimistic place after Barack Obama announced overnight that he had agreed a deal to raise the country’s debt ceiling and cuts to the deficit over the coming decade. However, it is important to recognise that the deal may still face opposition in the House of Representatives, where conservative Tea Party supporters and liberal lawmakers have already expressed dissatisfaction with the agreement. The Daily Telegraph reported that the plan involves a two-step process for reducing theUS deficit. The first phase calls for around $900 billion in spending cuts over the next ten years, and the next $1.5 trillion in savings must be found by a special Congressional committee.

Republicans had insisted on deep spending cuts before they would consider raising the $14.3 trillion limit onUSborrowing, turning a normally routine legislative matter into a dangerous game of brinkmanship. After weeks of deadlock and with the final outcome hinging on support from lawmakers, Obama pressured Congress to pass the deal. “I want to urge members of both parties to do the right thing and support this deal with your votes over the next few days,” Mr. Obama said in a televised address at the White House. But the President, like Congressional leaders, noted that it was not the deal he would have preferred but it was a compromise.

Financial markets inAsiashowed the first sign of relief after the debt deal was announced, with stocks and the US dollar rising while gold, the traditional safe haven, falling on the news. In theUK, and acrossEurope, equity markets opened up sharply, with the FTSE 100 up 1.2% at the time of writing.

It is very difficult to know what will happen once the default deal is signed. Speaking at the end of last week, John Greenwood, chief economist at Invesco Perpetual, commented, “My opinion is that a deal will be done. Ideally a deal would have been done already to facilitate the passage of legislation before the deadline. However, that is obviously not the case. But even knowing whether or not Obama and Congress will reach agreement doesn’t provide much insight as to the market outcomes. One reason is that globally there are many cross-currents at present, particularly the crisis in the eurozone, which makes theUSa relative safe-haven. Also, recent federal government revenue streams have been more buoyant than expected, which may mean that theUSgovernment can continue to fund itself a bit longer than previously thought, even without raising the debt ceiling.”

 

Default clouds the issue

While the potential default has been the headline issue for many, The Financial Times believes this is the tip of the iceberg, reporting that analysts believe only a credible deficit reduction can satisfy the ratings agencies and keep theUS from losing its coveted status. Whilst it looks as if a deal may come just in time to avoid a catastrophic default, Washington and investors will be closely watching to see if it goes far enough to convince credit rating agencies to let the United States keep its rating. The dysfunction in Washington, itself, could actually contribute to S&P’s assessment, with the world’s largest economy already tainted by the political squabbling that delayed action on the debt ceiling until the last minute. A credit downgrade would undermine confidence inUS solvency, which could stunt economic recovery prospects and send negative ripples through the international financial system whereUS bonds are bellwethers.China, holders of billions of dollars ofUS debt, has called the situation “financially irresponsible”.

Julian Jessop, chief international economist at Capital Economics, the City consultancy, warned that a default might only be averted at the cost of a shutdown of non-essential government services that could tip theUSeconomy into recession. He added that whatever happened over the next few days was unlikely to alter the fact that theUSneeded to be put on a much firmer footing. “This is what will ultimately decide the impact on financial markets,” Mr Jessop added. “The necessary fiscal tightening will be a drag on the US for years to come, keeping interest rates and government bond yields low.”

The worst case scenario of the US ‘running out of money’ is seen as unlikely; but, after recent years, the UK Treasury has learned its lessons and is keen to have contingency plans in place should the US eventually default on its debts. The Mail on Sunday reported that George Osborne, the Chancellor of the Exchequer, and Sir Mervyn King, the Governor of the Bank of England, have held frequent discussions and want plans in place ready for immediate action. It is thought that one of the options forBritain, and indeed central banks around the world, might be to waive the normal rules and allow banks to continue to treat US bonds as top quality capital, assets that currently form a core part of their capital buffers.

 

The week that was

The growing nervousness over the August 2nd gridlock caused markets to remain volatile throughout the week, while the dollar fell to an all-time low against the Swiss franc and gold hit another record high, at one point pushing above $1,630 per ounce on Friday. The ‘flight to quality’ left global equities nursing losses, with the largest weekly falls in more than a year. The FTSE 100 fell around 2%, closing the week at 5,815.2 and the S&P 500 more than 3.4%. European markets saw decreases of 2.4% andFar East markets 3%. On the currency exchanges, it was the Swiss franc and Japanese yen that took advantage of American woes. The brinkmanship on Capitol Hill also took its toll on US Treasury stock, as at one point the yield was higher than that offered by the British government, whose austerity programme is designed to keep the AAA rating and with it a manageable borrowing rate.

 

Eurozone taking a backseat

For once, the eurozone debt issues were not at the forefront of people’s minds, though there were still developments as Spainbecame the subject of media speculation. The Daily Telegraph stated that Moody’s warned that the Spanish were facing another threat to their credit rating due to not only its own economic problems but also its exposure to the Greek crisis. The agency has concerns overSpain’s “funding pressures”, and the challenge of meeting its austerity measures in a weak growth environment. In addition, the International Monetary Fund underscored the concerns in its regular report, saying that “downside risks still dominate the economic outlook, and problems will need continued and decisive policy action”. The general opinion seems to be that the ability ofGreece to meet its obligations under the second bailout package remains key to the longer-term stability of the eurozone.

 

Feeling the pinch

British households are suffering a tighter squeeze on incomes than the USor Europe, according to The Sunday Telegraph, due largely to the weakness of sterling. With real disposable income reducing by around 3%, the additional pressure is coming from rising prices for food and energy, which though a problem worldwide, is exacerbated by the weak pound. The British currency has fallen by around 20% against most major currencies since 2007, increasing the cost of any imported item, and the country is enduring its biggest fall in spending power in 34 years. Some economists believe that the Bank of England should raise interest rates to strengthen the pound and reduce import inflation, but the Monetary Policy Committee is still expected to leave rates on hold this week for the 29th month running.

Official statistics last week showed theUKrecovery is yet to take hold, with the country only able to grow 0.2% in the second quarter of 2011. Poor data will reinforce the market’s opinion that the MPC will not raise rates until the second half of 2012, and any weakness in the economy will be compounded by soaring inflation as scheduled household fuel price rises take effect. The paper opined that there is little the Bank can do to lower inflation as currencies only really appreciate in value when markets believe the economy is strong, which increases capital inflows. Norman Lamont famously attempted this on ‘Black Wednesday’ and ultimately failed.

 

Results week

The City will be poring over an expected mixed set of interim results from the big fiveUKbanks this week, looking for signs of potential job cuts and the impact of the eurozone crisis. HSBC’s chief executive, Stuart Gulliver, has been reported to be looking at 10,000 job cuts as part of a programme to save over £2 billion per year. While headline figures such as HSBC’s expected $11 billion of pre-tax profit are eye-catching, analysts will be more interested in whether the eurozone crisis has increased the banks’ borrowing costs, and whether customers are defaulting on their loans.

Royal Bank of Scotlandand Lloyds Banking Group are expected to reveal the damage caused by a combination of Greek debt writedowns, market volatility, and huge charges to pay for mis-selling of payment protection insurance. According to The Sunday Times, the losses could be as much as £1 billion for RBS and £3 billion for Lloyds over the first six months of 2011, hindering the government’s plan to reduce the taxpayers’ exposure to the pair. Although both banks are perceived to be through the worst of their problems, the figures are down from the same time in 2010, after Lloyds posted a profit of £1.3 billion, and RBS scraped a £9 million profit. RBS, which is 83% owned by the taxpayer, is by far the most vulnerable to Greece, with a gross exposure of around £1.6 billion inherited through its acquisition of Dutch bank ABN Amro, a heavy investor in eurozone government debt.

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