The Nitty Gritty Details:
This morning’s flat stock and Treasury market opens reflect Wall Street’s continued confidence that a debt deal will get done by the August 2nd deadline. Market watchers are finding reassurance in reports the two sides are close, shrugging off last night’s partisan jabs between Obama and Boehner on national television that painted a more divided picture. Also helping is generally positive earnings news. Today’s economic calendar includes new home sales, consumer confidence and weekly chain store sales, none of which is likely to be particularly market moving with all eyes on Washington. An Italian debt auction and some weak earnings from three well-known companies weighed on European markets, while Asian markets were largely higher with the exception of India after its central bank hiked interest rates. Commodities are broadly higher, led by copper’s more than 1% advance. U.S. crude is inching higher toward the $100 mark, while gold is up marginally near $1615 an ounce.
Looking back at Monday, the broad averages closed lower, though stocks pared losses during afternoon trading to end only a half percent lower. A debt deal in Washington did not arrive, supporting gold and safe-haven currencies while weighing on stocks as well as Treasuries and the dollar. Earnings news was positive, but limited. While Utilities was the only sector to finish higher, Technology had only a minor decline of 0.1%. Despite the jittery market, three defensive sectors fell the most (Telecom, Health Care and Consumer Staples).
Around our financial planning services firm this morning, we were discussing four items that we thought would be of particular interest to our readers:
The Markets Broken Down:
1. Treasuries may lose their AAA rating regardless of a debt deal. All three major ratings agencies – Moody’s, S&P, and Fitch – placed Treasuries on watch for a downgrade in mid-July, but of the three, S&P has taken a harsher tone stating that it would like to see meaningful steps to reduce the long-term deficit to avoid a ratings cut. With time running out on a more substantial deficit reduction package, S&P may therefore downgrade Treasuries in coming weeks or months after it reviews any debt deal.
2. In the event of a downgrade, bond market reaction may be muted. Prior sovereign downgrades have elicited only minor market reaction in the subsequent week. Downgrades of Japan (S&P 2001), Italy (S&P 1998), and Spain (Moody’s 2010) witnessed only a negligible change in their respective 10-year government yields. Exceptions include Japan (Moody’s 1998), which witnessed the 10-year yield rise by 0.15% after one week (amidst the Asian crisis), and Spain (S&P 2009), which witnessed a 0.30% rise in its 10-year yield in response to a growing European debt problem. The United States is not as debt burdened (relative to GDP) as Spain and Italy and therefore different.
3. And speaking of the bond market, it has yet to fully price in a downgrade. This is reflected in increased Treasury volatility and the 30-year Treasury bond which has “whipsawed” between a 4.17% to 4.32% yield multiple times since mid-July. The CME increased margin requirements for Treasury futures slightly in response to increased volatility. The market appears to be grappling not only with the uncertainty with what a debt deal may look like but also if a downgrade is forthcoming.
4. In the event of a downgrade, Mortgage-Backed Securities (MBS) and agency debt would also be affected. So far, neither market is showing problems with the potential loss of a AAA rating and yield spreads on both sectors have remained relatively stable. Including Treasuries, this implies that roughly $19 trillion of U.S. debt could be downgraded. Investors would have a very difficult time replacing that kind of liquid, high-quality dollar denominated debt.
As always, email me here with your questions or comments. I love to hear from you and thoroughly enjoy the “intellectual debate” with our clients and friends that these opinions generate.
Greg Powell, CIMA
Note: The opinions voiced in this material are for general information and are not intended to be specific advice. Any indices such as the S & P 500 can’t be invested into directly. Past performance is no assurance of a future result.
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