The US downgrade: historical watershed or non-event?

STANDARD & POOR’S (S&P’s) decision to cut the US’ long-term sovereign credit rating from AAA to AA+ was an unprecedented event. It was the first time ever that the US was downgraded. In the future, it is possible that the demotion could be seen as a major symbol of relative US decline. But for the moment, it would be unwise to rush into exaggerated conclusions. The global position of the US remains pivotal.

S&P’s move was dramatic but also farcical, with a huge statistical error of $2tn in its initial announcement of the downgrade. The timing of the rating agency’s decision, at the end of an exceptionally volatile week, has been criticised as irresponsible, and has reignited perceptions that the credit agencies are incompetent, and that their views are given excessive importance.

The unedifying political bickering in Washington before the debt ceiling was raised, which brought the US government to the brink of default, suggests that the credit downgrading is, on balance, justified. However, other major rating agencies are retaining the US rating at AAA. It is legitimate to ask whether, in any fundamental sense, the US is now less creditworthy than countries that are still enjoying the top rating, such as Germany, France, the UK, Austria or Finland.

In the aftermath of the US demotion, there was exceptional market turmoil: share prices plummeted in most regions and risk appetite fell sharply. But US Treasury bond yields fell back within days to levels below those prevailing before the credit downgrading. The world is indeed a more dangerous place, but US paper remains one of the safest assets. The US fiscal deficit is clearly too large, and the pace of its planned reduction is inadequate, but there is still no serious doubt about whether the US government will be able to repay its debts, which are mostly denominated in dollars.

Political uncertainty

So the uncertainties are not financial; rather, they mainly relate to the willingness of US politicians to honour their obligations. The US political system has recently become more dysfunctional, and the drift towards extreme ideological positions will make it more difficult to form the broad consensus required on matters of national importance.

The markets are increasingly dominated by fears that growth prospects are deteriorating, both in the US and globally. US GDP grew at an annualised rate of only 1.3% in the second quarter of 2011, well below the consensus that predicted 1.8% growth. An even more disappointing figure was the sharp downgrading of first-quarter US growth to a negligible 0.4%, from the previous estimate of 1.9%.

Revisions to earlier figures also reveal that the 2007-09 US recession was worse than formerly estimated: the peak-to-trough GDP drop was 5.1%, compared with the previously reported fall of 4.1%. Although the job figures for July were better than expected – 117,000 new jobs were created and the unemployment rate was down marginally to 9.1% – US job creation is still inadequate. It may take at least three to four years before the unemployment rate returns to pre-recession levels. Our US GDP growth forecast for 2011 has also been cut drastically to 1.8%.

In the face of mounting fears over weak growth, the US Federal Reserve has taken the very unusual step of stating publicly that it expects economic conditions to warrant exceptionally low levels for the Fed funds rate until at least mid-2013. By announcing its key policy interest rate two years in advance, the Fed is giving up its freedom to act.

However, the Fed has not offered any legal commitments. If economic conditions were to change, it would raise rates sooner. But the Fed has given a strong indication of its intentions, and it is extremely unlikely that its key policy rate will be raised before the final months of 2012 at the earliest. Weak growth may also persuade the Fed to launch a new round of asset purchases in another round of quantitative easing, despite its earlier reluctance to do so.

Spreading debt crisis

The market pessimism has been reinforced by concerns over the implications of the worsening eurozone sovereign debt crisis. Tensions have eased temporarily following the Greek bailout package agreed in July, which came to a total of €109bn (£95m). But the positive reaction was short-lived, and the markets still expect Greece to default in the next two to three years.

More seriously, the crisis has recently spread beyond Greece, Portugal and Ireland. It is now engulfing big economies, as pressures have built up against Spain and Italy. Sovereign debt concerns are threatening the stability of banking sectors across the eurozone, and sharp falls in French bank shares highlight the risks involved. In the face of dangerous increases in yields, the European Central Bank (ECB) has decided to buy Italian and Spanish government bonds in a dramatic move that reversed its earlier reluctance to intervene directly. While helpful, this will not provide a lasting solution.

Meanwhile, the ECB remains more concerned about inflation than the Fed; as expected, it raised its key interest rate in July from 1.25% to 1.50%. More increases are likely, but at a slower pace: the next rise is expected early in 2012. In the UK, growth has been disappointingly weak, with GDP growth in the second quarter provisionally estimated at only 0.2%. Although UK annual inflation is still above 4% and expected to rise further in the short term, the Monetary Policy Committee is still unlikely to raise official rates until the second quarter of 2012 at the earliest. ?