US downgrade’s impact worldwide: Worse than Lehman collapse

A downgrade in the US credit rating will trigger a massive sell-off in treasuries

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I joined the hedge fund industry in November 2009, a point when the US was supposed to be on its way out of its worst recession in five decades. It was a good time to be a part of a credit hedge fund. The fixed income markets were at an all-time low owing to fears of massive defaults by corporates due to their inability to generate cash and/or obtain refinancing from banks. If one did his homework correctly, one could unearth many ‘hidden gems’ that were driven by robust domestic demand in Asia and had nothing to do with the events in the US. Indeed, many fund managers took advantages of these mispricings and 2010 was a good year for fixed income funds in Asia. I was lulled into believing that the worse was behind us. Needless to say, I couldn’t have been more wrong. Today, we are at a juncture where:

 

·         Europe is embroiled in a messy sovereign debt crisis which at its worst can threaten the very existence of EU and the euro, not to mention spark widespread contagion.

 

·         The Middle Eastern countries are going through a series of democratic uprisings which can disrupt oil supplies at least in the short run.

 

·         There are murmurs about trillions of dollars of bad debts on the books of Chinese banks. Add to this my personal belief about an impending corporate debt crisis in China over the next 18-24 months.

 

And to top it all, now we have the danger of the US losing its AAA rating if it doesn’t manage to raise its debt ceiling on August 2 2011. Not many people still understand the ramifications this shall have on the world and on their lives. They just have to cast back their minds to 2008 on the contagion that was triggered when Lehman collapsed; this is going to be a thousand times worse. While EU has managed to prevent a sell-off for the time being by putting together a second bailout package for Greece, all eyes are now on the Democrats and Republicans in the US to save their country and save the world in the process. So what would be the effect of a downgrade in US’ credit rating? Take a look.  (Note: I am not even going to talk about the impact of the same on US’ financial prestige.)

 

 

Massive sell-off: By regulation and mandate, most top banks and institutional investors can’t hold paper below AAA rating. Consequently a downgrade in the US credit rating will trigger a massive sell-off in Treasuries all over the world. I can hardly overstate the impact of this:

 

·         The US government is the biggest holder of Treasuries in the world. They would be sitting with a notional loss worth billions of dollars on their books.

 

·         China holds an estimated USD1.5 trillion in US government debt. The downgrade would hit their P&L quite badly as well.

 

·         Many other countries including the UK as well as world’s top banks shall face the same issue.

 

Contagion: The US market is complicatedly coupled with world economies. A rating downgrade can potentially put the stock and bond markets in virtual free fall all over the globe. Companies that rely on demand from US (and Europe) for their growth can see their scrip stay hammered for a long time to come. This shall lead to massive layoffs and unemployment worldwide.

 

Depreciation of the USD and inflation in the US: As investors shall look to shun Treasuries and move out of the USD, the greenback shall experience depreciation in value. This would intensify inflation risk for the future which shall be catastrophic for a country that is desperately trying to stimulate consumer demand to revive its economy.

 

USD as the reserve currency: The USD’s status as the world’s reserve currency has been challenged several times in the past two years and the country’s loss of position among the highest rated government borrowers might be the last straw that shall make the world look for a replacement. While the euro got battered last week (and might get again in the future) due to the uncertainty over the debt of Greece and other EU sovereigns, China has been steadily trying to internationalize the renminbi and aspires to make it a part of UN’s Special Drawing Rights (SDR) basket by 2015. Needless to say, a shift to SDR as the reserve currency shall suit China completely.

 

Rally in commodity prices and ‘haven’ currencies: Even as I write this article, gold prices are an all-time high as investors look for safe-havens to park their funds. A downgrade will lead to a further rally in commodities and haven currencies like the Swiss franc, as these investors shall look to ride out the period of uncertainty that would follow the downgrade up until the complete impact of the same starts getting clearer to the market.

 

Credit analysis: A downgrade of the US debt rating was unthinkable even up until recently. The entire mechanics of credit analysis is designed around benchmarking bonds against US Treasuries (the risk-free rate as freshly minted MBA grad would tell you). A downgrade would mean that the Treasuries aren’t ‘risk-free’ anymore. Analysts shall have to change their benchmarks (maybe the Bund) while universities shall have to change their textbooks.

From media reports, it seems that Democrats and Republicans are only too aware about the impact a deadlock on August 2 can have. The market (including myself) largely expects the two parties to come up with some sort of compromise to raise the debt ceiling. However there have been ‘Black Swan’ events in the past and if we have one on next Tuesday, people shall wake up to a completely different world on Wednesday.

 

Tanuj Khosla is currently working as a Research Analyst at 3 Degrees Asset Management, a fund management firm in Singapore. He can be followed on Twitter @Tanuj_Khosla. Alternatively he can be reached at khosla.tanuj@gmail.com. Views expressed are personal.

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Date

27 Jul 2011

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