The decision to downgrade was executed even more sloppily than the haphazard lead up. To review my earlier comments, the baseline scenario of the original warning was created in such a way as to make avoiding downgrade impossible:
My take on this is that we are highly unlikely to achieve even the baseline, and that is without the GDP-killing impact of $4 trillion in austerity measures. Worse still, given their opaque calculations, they have every option to change their calculation metrics at will, and thus move the goalposts. This looks to be a recipe for unending credit enforcement, at the whim of an entirely unaccountable private organization, regardless of whether we deliver the demanded cuts.
And now they have in fact moved the goalpost, by changing their baseline assumption about the Bush era tax cuts from an original assumption of repeal to a new realization that they are unlikely to be repealed in this political environment. How they missed the ineptitude of the December budget negotiations in their original assessment is unstated, but there you go.
The whole thing is a farce, from the absurdly telescoping timeframe I referred to below to the $2 trillion calculation error discovered Friday afternoon, which appears to have been meaningless in their view. It is impossible to draw any other conclusion than that S&P has entered the world of political enforcement of the austerity agenda.
As for whose agenda that might be, my original thought below was to compare S&P’s function to that of the IMF in the third world, but that comparison seems limited. What does the ECB, and specifically Germany, gain from the austerity measures being imposed on the PIIGS? Who gains from the austerity measures in the UK, which has now had four quarters of flat growth and stagnating employment as a result? The answer in the first case is banks in the core of the EU, though the answer is less clear in the latter case.
Whoever it is, it is very clear that S&P has set up the entire dynamic so that a downgrade was going to happen, one way or another. Now that it’s here, I’m hopeful that we have some room for a lessened impact due to the fact that Moody’s and Fitch, the other two NSROs have maintained the AAA rating of the US. As I should have mentioned below, most guidelines and regulatory frameworks specify X% in securities/exposures rated AAA by at least two agencies, which means that the impact on regulated portfolios with such guidelines is likely to be quite muted.
I think there are two bond market dynamics that will be particularly interesting to watch in the coming weeks. In the very near term. Friday’s release noted that S&P will issue their ratings guidance on “affected ratings in the funds, government-related entities, financial institutions, insurance, public finance, and structured finance sectors” on Monday. That guidance will affect up to 78% or so of the investment grade taxable market as I pointed out earlier. It will be a fascinating test case of just how broadly the federal credit guarantee has been stretched in recent years.
In the longer term, the one area that will be absolutely certain to suffer financially is municipal debt at the state and local levels. I did not realize until last week that the largest line item of funding for each state’s budget is federal money in the form of block grants and other funding mechanisms. That federal revenue will be substantially reduced in the absence of further stimulus, which means that the agencies won’t be far behind. As a result, it would be fair to expect substantially more turmoil in municipal bond funds than in traditional taxable bond funds (though I am not a financial advisor and that is in no way advice).