Today is the first business day which the UK faces without its AAA credit rating is the spin being imparted widely in the media. In fact LBC radio has just on the 9 o’clock news gone to a reporter who told us breathlessly “the UK has just lost its perfect credit rating”. So let us take her back to the 4th of June last year. From Reuters.
Rating agency Egan-Jones cut the credit rating for the United Kingdom on Monday to AA-minus with a negative outlook from AA
So breathless reporters across the breadth of televison and radio land have been somewhat economical with the truth over the weekend. Also seeing as Egan Jones were ahead of the pack let us look at why they made their move.
The over-riding concern is whether the country will be able to continue to cut its deficit in the face of weaker economic conditions and a possible deterioration in the country’s financial sector………Unfortunately, we expect that the UK’s debt/GDP (ratio) will continue to rise and the country will remain pressed.
As we look at the rationale we see that Egan Jones was not only ahead of the ratings pack it was in fact accurate in its analysis. We also see that what are called the major ratings agencies are, as we so often observe, off the pace as only one out of three has caught up nearly nine months later.
The major ratings agencies
Our breathless reporter may have taken some time to wonder how about how discredited ratings agencies can have the gall to call someone else’s credit to account! Also there is the irony of them taking away a AAA rating when their awarding of it to what was anything dressed up as a mortgage backed security was a major factor in causing the credit crunch. In a fairer and more ethical world they would have been closed down. Instead we see failure rewarded one more time as if anything their importance has risen in a perversion of any concept of a proper incentive structure.
We had in fact been vulnerable for some time
Back on March 15th 2012 I pointed out this.
The painful truth is that the UK is no longer a AAA credit risk
I also gave my view as to how financial markets might respond to this.
So as ever the ratings agencies are off the pace and should have reduced our rating a while ago. In the end they will get around to it which will no doubt create a media storm but may affect markets very little because in reality we are not a “AAA” nation.
What did Moodys actually say?
the UK’s economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the UK economy from the ongoing domestic public- and private-sector deleveraging process.
So as is often true the basic analysis is accurate but tardy. Invariably the recipient of the analysis denies it although actually in this instance there has been little of that. The consequence of this analysis leads Moodys to echo Egan Jones.
The sluggish growth environment in turn poses an increasing challenge to the government’s fiscal consolidation efforts……Moody’s now expects that the UK’s gross general government debt level will peak at just over 96% of GDP in 2016.
However there was something missing as I recall what Moodys downgrade of France told us.
The missing effect of Quantitative Easing
When Moodys downgraded France they told us this only last November and the emphasis is mine.
unlike other non-euro area sovereigns that carry similarly high ratings, France does not have access to a national central bank for the financing of its debt in the event of a market disruption.
I raised this as an issue at the time as not only does the UK have such a central bank, the one it has the Bank of England has been extremely enthusiastic in its pursuit of Quantitative Easing. Indeed three out of nine Monetary Policy Committee members voted for a further increase in QE from £375 billion to £400 billion at the last meeting.
Just to be clear I thought at the time that such thinking was limited intellectually but we now add one more problem to the ever growing list concerning ratings agencies which is that they are inconsistent.
In this vein perhaps the biggest irony was the fact that Moodys also cut the credit rating of the Bank of England! But it can print Moodys…..
Still perhaps they have changed thier mind on this subject which would be for the best.
How will UK financial markets respond?
The international view
If we look back to the impact of the loss of the AAA rating on the United States and France we saw that contrary to the media view of doom and gloom their national bond markets both then rallied rather than fell.
This contrary effect has two main drivers I think. Firstly whilst in our perverse world some investors find themselves via their investment criteria beholden to ratings most have lost faith in them. This feeds into the fact that the tardy response time of ratings agencies means that markets are likely to have got their retaliation in first.
Sterling will collapse will it?!
I am sure that you have read and seen this headline repeated many times over the weekend. But if we pause and think we see this.
1. The pound was falling anyway as against the US Dollar for example we had fallen in 2013 by more than 6% in 2013 so far.
2. Such media hype is often a reverse indicator. For example a trading rule of thumb is to reverse any such headlines in the Sunday Times which was full of the pound will collapse stories and how you can protect yourself. If nothing else I was fascinated to see how you could protect against falls which had already happened!
For the record the pound was hit initially to US $1.506 but has since recovered a little to US $1.514 as I type this.
The UK Gilt market
Again the media hype is that UK government bonds or Gilts will do some version of collapse or fall leading to a surge in interest-rates. Unfortunately for them it has in fact been falling since late summer 2012! So we see that markets had concerns for some time as the UK benchmark ten-year government bond yield rose from 1.46% to 2.11% as prices fell.
As I type this the UK Gilt market is unchanged this morning so far have initially fallen and then rallied back to where it started.
The FTSE 100
We have to look at a different set of concepts here as the FTSE 100 has rallied strongly in 2013 so far being up by around 8% on where it started the year. As an aside the comments section has discussed the fact that there is presently a very strong correlation between equity market rises and currency falls,which has benefitted holders of UK equities. Moving back to the FTSE 100 it seems to be continuing the same trend as it is up 0.5% at 6365 as I type this. So no signs of crisis there!
This will be welcome in a corner of Canada
I would imagine that the incoming Governor of the Bank of England was very grateful that this did not happen on his watch. I did try to listen very hard for the sigh of relief but failed! Perhaps he was busy on the telephone telling Mervyn King that he should take this one for the team.
So having reviewed the situation I am relatively sanguine about an event I was expecting for some time. If you look at market behaviour it is plain that they were pricing in the issues discussed by Moodys in the downgrade long before it happened. As ever it is hard to exactly sure because should the pound now fall it would only be continuing what it was already doing! What we can be sure of is that after the initial shock effect UK financial markets seem sanguine too. For myself I will be interested to see if the Sunday Times headline works one more time as a reverse indicator.
This does not mean that there will be no consequences of the move as the UK Chancellor George Osborne had placed heavy and indeed undue and unwise emphasis on our AAA rating. I note that some are already pressing for more infrastructure spending and a past member of Mindful Money Gemma Godfrey has suggested this in today’s Guardian live blog.
infrastructure spend is classified as ‘capital’, not ‘current’, spending, and with a £3 boost to the economy per £1 spent
My immediate thought was is this the equivalent of perpetual motion? Also how did anything ever go wrong? So I asked who produced the number and she told me it was the Confederation of British Industry or CBI. Yes the same CBI whose members would benefit from such spending as the moral hazard meter is called into action one more time.
Meanwhile we remain mired in stagflation.