A U.S. ratings downgrade is a non-event

Whether or not the debt-ceiling increase will be passed on time, the U.S. credit rating is vulnerable to a downgrade by the rating agencies. Various news reports portray such a downgrade as a watershed event which will send interest rates skyrocketing and the economy into a tailspin. That is unlikely to happen. Other large developed countries - such as Japan - have seen their ratings downgraded without any meaningful borrowing cost increases. Further, the criteria used by the ratings agencies to determine a country's credit rating - such as the debt to GDP ratio - deserve a more nuanced analysis including whether they are actually relevant. As Shiller points out:

Debt-to-GDP ratios tend to increase for countries that are in economic trouble. If this is part of the reason that higher debt-to-GDP ratios correspond to lower economic growth, there is less reason to think that countries should avoid a higher ratio, as Keynesian theory implies that fiscal austerity would undermine, rather than boost, economic performance. 

The fundamental problem that much of the world faces today is that investors are overreacting to debt-to-GDP ratios, fearful of some magic threshold, and demanding fiscal-austerity programs too soon. They are asking governments to cut expenditure while their economies are still vulnerable. Households are running scared, so they cut expenditures as well, and businesses are being dissuaded from borrowing to finance capital expenditures.
The lesson is simple: 

We should worry less about debt ratios and thresholds, and more about our inability to see these indicators for the artificial – and often irrelevant – constructs that they are.

A ratings downgrade in itself is not a concern - if it was, markets would have already reacted strongly. What IS concerning is the country defaulting. This could wreak havoc in the financial markets who depend on short term liquidity and set off a host of unpredictable events. 

Wages are falling - An ugly jobs report

Tim Duy's Fed Watch:

The employment report polishes off what was already a depressing week.  The turn of events in the budget negotiations was deeply distressing.  It just seemed like it should be impossible to imagine that budget cutting is the order of the day when unemployment is over 9%, 10-year Treasuries hover near 3%, and a Democrat is in the White House.  Yet possible it is. 

The extent to which our leadership seems determined to follow in the path of the Japanese is absolutely stunning.  My impression of the last two decades is that Japanese policymakers were never able to keep their eyes on the weak economy, instead always eager to turn their attention back to "normalizing" policy – raising interest rates, raising taxes, cutting spending.  Our leadership suffers from the same obsession. 

The employment report should be a wake up call.  A slap in the face.  A bucket of cold water poured over your head.  But it won’t.  I suspect it will be seen as further evidence that stimulus is pointless, that austerity is the only solution.  

Weakness spread far and wide throughout the report.  No way to put lipstick on this pig.  As others have noted, the labor force fell, the participation rate fell, the employment to population ratio fell, the number of employed plummeted, and the number of unemployed climbed.  Private nonfarm payrolls gains a paltry 57k, and the drag from government cutbacks pulled the overall jobs gain to just 18k.  Far short of the numbers needed to even hold unemployment steady.
And wages fell.  Just a penny an hour, to be sure.  But that penny is meaningful given the desperate fears of inflation that appeared to take hold on Constitution Ave.  Without sharply rising wages, those fears are simply unfounded.  This was the lesson of the post-1984 period.  Why monetary policymakers are fixated on the pre-1984 period is a mystery. 

What I noticed was the number of short-term unemployed:

 

A sharp rise in the number of people thrown into unemployment is definitely a red flag.  The overall data picture is not pointing at recession yet, but this number reeks of something bad.  

We can only hope some of the downward pressure on growth is relieved as the tsunami related disruptions fade and, more importantly in my mind, the sharp rise in oil prices has been arrested, at least for the moment.  But even as these restraints lift, what remains?  Oil prices have not plummeted like in 2008 to provide a big positive boost to real spending.  And interest rates are no longer falling to provide and opportunity for a refinancing boom.  So at best we return to trend growth, maybe a little above?  Trend growth that was never sufficient in the first place? 

Moreover, we still face significant headwinds in the second half of the year.  The Europeans are determined to avoid resolution in their ongoing debt crisis.  The ECB is determined to raise interest rates.  And Congress and the White House are determined to pursue a path of fiscal austerity.  

Bottom Line:  Simply a weak report – unbelievably weak given the “recovery” is two years old.  Weak enough – especially given falling wages – that it should prompt Bernanke & Co. to revisit their commitment to end large scale asset purchases.  The next round of Fedspeak will be very interesting.  Watch closely for the focus on “temporary” factors - code for watch and wait.  At this juncture, they are still out of the game.  I think the Fed will need to see another quarter of data before they begin to take seriously the possibility that they once again erred with a premature policy shift.

Partying on the Edge of the Eurozone Volcano

The latest proposal in the Greek debt rollover saga is intended to achieve two inconsistent objectives. The first is for eurozone governments to ensure that private sector banks contribute to a bail-out (at Germany's behest). The second is to ensure that participation in the plan is seen as voluntary by the rating agencies, thereby avoiding a declaration of default. The outcome, however, is a default in all but name writes Wolfgang Münchau at the Financial Times:

If you own a Greek bond that matures by June 2014, you keep 30 per cent of the redemption as cash, and roll over 70 per cent into a 30-year Greek government bond. The Greeks will have to pay an annual coupon, or interest rate, of between 5.5 per cent and 8 per cent. The precise rate will depend on future economic growth. 

Of the money received, Greece will lend on 30 per cent to a special purpose vehicle, another well-known construction from the subprime mortgage crisis. The SPV invests into AAA-rated government or agency bonds, and issues a 30-year zero coupon bond. The purpose of this is to guarantee the principal of the 30-year Greek government bond that you just bought. 

With this construction, the downside to your losses is limited. Depending on how some of the parameters of this agreement evolve, you will probably make a small loss, relative to the par value of your holding. If you are lucky, you might come out positive. You will probably not be lucky. But you will still be better off than if you sold today, or if Greece were to default. More important, the accounting rules allow you to pretend that you are not making any losses at all.
If this was any other field of human activity, you would go to jail if you accepted, let alone made such an indecent offer. 

It is also inevitable that Greece will default on its coupon payment at some point. The interest will be 8 per cent under a benign growth scenario, and 5.5 per cent under a not so benign one. Either way, Greece cannot pay such a high level of interest. 

As Jeffrey Sachs pointed out last week in the Financial Times, if you really wanted to achieve Greek debt sustainability, you would need to reduce the interest rate to about 3 per cent. This is what Germany pays for 10-year bonds. And even then would you have to extend the maturity of those bonds as well. Neither is, unfortunately, on offer. All there is, is this dirty little con-trick. The complexity of the scheme is due to the need to persuade the rating agencies not to attach a default rating to Greek bonds. 

The rollover agreement represents, from an economic point of view, nothing but a collateralised bond. It subordinates all other bondholders. The rating agencies would normally not hesitate to attach a default rating to Greek government debt. So the solution is to create a complex structure, and claim that it is technically not a collateralised bond, but something that defies definition. 

Unfortunately, S&P has already called the bluff, saying the leading proposal under consideration would bring the country into default. Even if the finance ministers eventually succeed with their contraption and the rating agencies withhold their judgement Münchau writes that "the politics of crisis resolution in Greece [are highly likely] to become even more difficult, and accident-prone. We are not just “kicking” any old “can down the road” any more. This is a can of explosives."

EM: Thailand's elections

FT's excellent tilt blog on continued political risk in Thailand post-election:

"Investors are perhaps too sanguine about prospects for a smooth transition to a new government," Ubhi said, listing four reasons why some caution is in order. 

First, the Election Commission is investigating a petition to dissolve Yingluck Shinawatra's Pheu Thai Party on grounds that it is effectively run by Thaksin, who is banned from Thai politics and now lives in exile in Dubai. 

Second, Yingluck herself is likely to face formal allegations that she committed perjury in the asset-concelament case against her brother, and could well be disqualified from leadership, Ubhi said. 

Third, the prospect of Thaksin being granted amnesty and being allowed to return to Thailand and not serve any jail time, is likely to spark renewed unrest. Anti-Thaksin protesters have held rallies and caused severe disruptions in recent years, for example, forcing the closure of airports in Bangkok in 2008. Thaksin, after the election, said he wanted to retire and had no desire to return as prime minister. But not many people believe that. 

Finally, while key military leaders are said to have accepted the result, it was the army that ousted Thaksin in 2006, and many of the same generals are in charge today.

The End of QE2

QE2 ended with a whimper on Friday. The 10-year US bond ended the day at 3.2%, defying predictions of many financial market commentators that we'd see rates soaring. I previously argued that soaring rates were unlikely when QE2 concluded.

But, never mind that financial commentators had warned about soaring rates when the 10-year bond rate was 3.6 or 3.7. The small bump to 3.2% after it had briefly fallen to 2.9% is entirely due to irrational optimism that the Greek problem has been solved. It isn’t exactly what financial commentators were telling us would happen with US interest rates.