Enhancement through Lower Regard?

Today the leading credit rating agency Standard & Poor's (S&P) announced that they have given a "negative outlook" to US government debt. This is not a downgrade in itself, but does provide a more specific qualitative assessment when combined with the rating itself.

What does it mean, and what have the reactions been to the announcement? In one sense, it means nothing new at all: the rating remains AAA, and S&P had already provided warnings that it would consider downgrading US debt if we did not get our house in order. S&P indicated that its negative outlook suggested there was a 1-in-3 chance that the rating could actually be downgraded within the next two years.

I am guessing, and I hope that it's true, that this means that about 1/3 of the times that they have provided a negative outlook on AAA debt in the past (over some reasonable amount of time observed), they have ended up downgrading the debt in the following two years. I hope that it does not mean their assessment of "probability" in the specific case of the US government's debt, because that would be completely bogus. The actual event depends on a whole lot of possible contingencies, some political, some economic; it would be ludicrous to estimate a "probability" on the outcome, and anyway I can tell you my strongly felt opinion--the chances that they would downgrade US debt, short of some sort of default, is zero. To do otherwise would be to invite a political cataclysm which would lead inevitably to S&P losing its duopoly status at the top of the credit rating game with Moody's. They aren't that dumb.

One question that has been asked today is: "Who cares what S&P thinks?" This blog has certainly been unstinting in our criticism of the principal rating agencies' performance in recent years, and creation of a new, better business model for rating debt quality is one piece of unfinished business from last year's financial reform. In this case, the US government is not paying S&P to provide a rating, so their opinion may be more untainted than usual, and what I see S&P reacting to, and also trying to forestall, is the fear of a credit crisis due to failure of the US government to a) develop a long-term deficit program of some sort, and b) raise the debt limit when it comes in a month or so. S&P is providing a warning from the credit markets, which both parties' strategists would do well to heed.

This is not to say that the Obama Administration need be governed by the desires of the bond markets; there are lots of forms of long-term debt reduction and short-term debt limit increase which would forestall a crisis. It is also a mistake to think that the markets speak with one voice: there are even some "experts" out there who are advising politicians not to compromise their values, to go up to the brink and even over it if necessary, that a default would not be catastrophic to our attempts to escape the Great Crater. Those voices should not be heeded.

Today's sharp drop in stocks (slight firming in bonds, gold, and the dollar; also a drop in oil and other commodities) may be much more meaningful than S&P's squawking. It appears to me that a new consensus is developing around a slowing of the pace of growth; with any additional government spending cuts around some sort of budget deal, even the partial one that is the best we could expect (see our recent forecast of the kind of agreement we should be able to get), we should expect nothing that will help recovery; only the absence of a collapse. In this scenario, there will be conflicting evidence affecting the markets, with slowed growth accompanied by possible rises in interest rates, prices, and flat job growth.

Thus, while the stock marketed overreacted, as per usual, with its immediate reaction to the "news" (in fact, a third of that reaction was corrected by the end of the day), it may still be in order for there to be a general retreat, until the quarterly earnings reports (and, especially, any future guidance) helps the market sort out the winners from the losers in the next few months.

As for the bond markets, they demand a lot but reward little. Today's announcement and its reaction produced public statements from both parties and from the White House, all pointing in the directions sought--more urgency on budget cuts and entitlement slashing from the Republicans, more urgency for a negotiation from the Democrats and the White House. It all may make a limited deal--the only one that's possible--more likely, but it won't be rewarded by anything more than the absence of a crisis and of a run on bond rates. I guess we should be grateful if we get small favors.