The S&P ratings agency downgraded the US long-term sovereign credit rating from AAA to AA+ with a negative outlook on 5 August. What does it mean for global FX? In our view, there are three issues to consider: what does it imply for risk appetite in the short run, what will the policy response be and what does it mean for USD prospects in the medium to long run?
We expect it to initially lead to a further rally in “safe haven” assets, in particular the JPY and CHF, which will likely be met by some policy response to weaken those currencies, but that will limit the appreciation not stop it. We do not recommend selling the USD: Treasuries are not going to sell off and the USD is likely to benefit initially from the risk impact of the shock but longer-run the fiscal problems are likely to mean a weaker dollar. Commodity currencies look most vulnerable in the short run, again because of the risk element.
A short-run negative shock to risk appetite
As “shocks” go, the announcement was simultaneously not very surprising and deeply shocking. Not surprising because S&P had been very clear about what it wanted to see in order for the US to maintain its AAA rating, and the agreement reached last week had not met those criteria. To many observers, it was really a question of when it would happen rather than whether it would. But it is yet another milestone in the ongoing financial crisis: another once-unthinkable event has taken place. For decades the 10y US government bond yield was the definition of the long-run risk-free interest rate; now that has been declared a less than top-notch credit risk.
We think the most likely outcome therefore is uncertainty about what it actually means in the short run. Our fixed income strategists think the implications for the US fixed income market are limited, pointing out that long maturity US government bond prices rallied significantly last week (see S&P downgrades the US long-term rating: First Impressions, 6 August 2011 for more details of their views). But one of the reasons for the attractiveness of US government debt is the extraordinarily difficult trading conditions at present, and this event is not going to lessen those difficulties.
We think that the normal pattern when bad news takes place is the most likely one to be repeated: relatively liquid assets, assets which tend to do well when global equities come under pressure, and assets where “speculators” had previously built up sizable short positions are all likely to outperform as investors flock to safe havens and square their positions. The USD looks attractive on all these criteria (see Figure 1 for the correlations of currencies with global equities) and therefore, despite the US-specific nature of the shock which we discuss below, we think it will likely perform fairly strongly. Indeed it is worth noting that when Japan was downgraded from AAA in 1998 the JPY initially appreciated (see US Portfolio Strategy Focus, 27 July 2011 for a discussion of what happened more broadly around that event).
Figure 1: The JPY and CHF have had the strongest negative correlation with global equities since the start of 2008 (correlation of weekly returns relative to the EUR)
Source: Reuters EcoWin
The JPY and CHF would also be natural beneficiaries of an event such as this, and we think that there will be significant demand for both currencies. The EUR and GBP are the other two currencies that look likely to benefit. Both have serious issues, and the EUR’s performance may be affected by announcements coming from euro area officials, but both are large, liquid currencies, relatively uncorrelated with global equity markets (and therefore with global wealth) and in both cases their own fiscal problems are being addressed. The commodity currencies appear most vulnerable. The AUD and NZD were the weakest performers last week, with the BRL, RUB and ZAR also coming under pressure. The SEK, while not a commodity currency, also tends to be strongly correlated with prospects for global growth.
In short, we think a sensible assumption is that currency performance will be roughly the same as the ordering in Figure 1, absent policy makers intervening to a significant extent.
Increased likelihood of intervention
Last week was eventful for a number of reasons, one of which was the increased activity of major central banks. The SNB, BoJ and ECB all made important policy statements. This week the FOMC meets and the BoE publishes its Inflation Report. How will global central banks react? It seems highly likely that if the JPY does appreciate in response to the S&P announcement – and we expect that it will – the Japanese authorities will intervene to weaken it again. Once a central bank starts intervening, it would be damaging for credibility to stop so soon. We do not think that the threat of intervention will be enough to stop flows into the JPY but actual intervention will work, at least up to a point. It may not stop the JPY from appreciating against most currencies, including the USD, but it will probably slow the appreciation.
The SNB is in a more difficult position. It effectively announced QE last week, and it is clear that the level of the CHF is a huge issue to Swiss policy makers. Despite the SNB announcement, the CHF was easily the strongest global currency last week and further appreciation absent intervention appears inevitable in this environment. We think that Swiss policymakers are highly likely to try to stop that appreciation, one way or another. Again, as is the case with the BoJ though, this is likely to limit currency strength, not stop it. In both the Japanese and Swiss case investors like to know which level being reached will lead to action. But in our view, the speed of any move is more likely to be the trigger. At a time such as this rapid appreciation can threaten financial stability which is on everyone’s mind at present.
The BoE, ECB and Fed will all want to sooth market fears rather than stop their currencies appreciating via direct means. The FOMC is unlikely to give the market a clear steer that QE3 is definitely on the way, but it will probably make clear that if it sees the need it will ease policy further. Overall, this would probably be a mild USD positive given some market participants’ expectation of a clearer sign that QE3 is coming. The BoE is likely to increase its inflation forecasts again and lower its growth forecasts somewhat, and is bound to give a gloomy steer to markets. Absent the turmoil in global markets it would probably be a GBP negative. At present, though, it may not be. GBP is looking more like a safe haven asset now than it has done at any time since the crisis began.
Some coordinated announcement by the G7 central banks is also possible. If so, it would likely be that short-term liquidity was being supplied to the market and that the central banks will do what is necessary to stabilise markets. In the short run, that would likely limit currency volatility rather than lead to any large rally in the risky currencies.
Longer-term another USD negative
In the very short-run then, we think that the S&P action will add to fears of another global slowdown and lead to a rally of safe-haven currencies including, ironically, the USD. But longer-term the US fiscal situation is likely to be another factor that adds to the pressure on the USD. One problem facing the peripheral European economies is that they cannot allow their currency to depreciate in order to stimulate their economies. But the US can. Indeed, the US already has as part of the natural transmission mechanism of loose monetary policy.
No investor we have spoken to expects a literal US government default of any kind. But almost all think that USD liquidity will increase further, that a lot of that liquidity will end up outside the US itself and that this will add to the desire of global portfolio managers to diversify away from the USD. A big difference between fiscal problems in Japan and the US is that the US has run a current account deficit for a generation. That has inevitably led to a huge stock of US assets being held by non-US residents. Unless the US current account moves rapidly back towards balance, and it is not going to, the only way that the rest of the world in aggregate can diversify away from the USD is by its price falling – depreciation.
The currencies that are likely to benefit from that over the next few years are those which are growing relatively quickly and where monetary policy needs to tighten in light of increasing inflationary pressure. This is likely to lead to a continuation of the outperformance of commodity currencies and Asia/Pacific currencies. But that is for the long run. Expect investors to batten down the hatches this week.
BARCLAYS CAPITAL
ECONOMICS RESEARCH | INSTANT INSIGHTS