What Next?

by Andrew Stuttaford

Over at Net Net, John Carney has a typically useful set of “slides” to help people work out what happens next in the markets. As he rightly points out, anyone who claims to know how this will spin out is talking nonsense. We are, as he says, in “unprecedented territory”. That’s not where investors generally like to find themselves (and it would be no surprise to see further market turbulence), but it needn’t mean disaster.

This is worth remembering:

S&P downgraded Japan’s credit rating in 2002. Many investors figured it would mean that Japanese bond prices would fall and interest-rates would rise. They rose a bit—but far less than the doom-sayers thought. Betting against Japan’s bonds became known as the “trade of death,” because it doomed so many people.

John also looks at the impact on the banks (and specifically whether they would be required to set aside more capital against their holdings of treasuries). For now it’s important to note that the Feds have announced that the risk weighting for “Treasury securities and other securities issued or guaranteed by the U.S. government, government agencies, and government-sponsored entities” would be unchanged. That ought to mean that they do not have to set aside (or raise) more capital, at least for regulatory purposes. Bank regulators elsewhere might take a different view, but I doubt it. There have been signs, particularly in Europe, that intra-bank confidence is faltering (look at the euro equivalent of the “TED spread” as a gauge of this – 3M EURIBOR over 3M German Bunds (“treasuries”) will do), something that (as we saw in 2008) can be devastating. I doubt if regulators will want to add to the pressure at this point.

Amongst the key questions that John addresses is where else holders of treasuries might put their cash (it can’t all go in gold…). They are not spoiled for choice, particularly in the sort of size that they would require. John mentions German government Bunds as one “beneficiary” of the American downgrade, but it’s worth remembering that if the Eurozone bailout fund has to be expanded to the extent that some now suspect (there is talk of  €2 trillion) the potential contingent liability that will be put on Germany (if it agrees to it) will be enormous. That would not be good for perceptions of Germany’s creditworthiness.

The real danger, I suspect, lies in the knock-on effects. It is there that the black swans lurk. John discusses money market funds, counseling calm, and suggesting that if any were to break the buck that it would not be for long. He also mentions this:

U.S. Treasuries are used to collateralize all sort of obligations, including margin requirements, short-term loans, and derivatives. Counter-parties may be able to require those on the other side of their transaction to provide more of the downgraded bonds as collateral-backing obligations. This could slow some transactions and make markets less “efficient” than they might be otherwise.

That touches, I think, on something that’s key. Probably the most important element of the global understanding of risk is that the credit of the US government is (forgive the phrase) the gold standard, the cornerstone. To the extent that that standard has now been tarnished by the downgrade (rather than the realities that the downgrade may or may not reflect) that will mean that “all” risks will now have to be reassessed, not only against that tarnished gold standard, but also against each other.  If I had to guess, it’s there that danger may lie, not least because the period in which that recalculation is done is likely to be one in which market appetite for risk falls sharply.

But to reiterate, like John, I don’t know what happens next. Nobody does. Navigating the markets is always a matter of guesswork, sometimes educated, sometimes not. And that guesswork has just become a little (or a lot) more “not”. 

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