When the UK loses its AAA rating it will probably have a beneficial impact

Firstly thank you to those who sent good wishes about my recent spell of ill health. As you can imagine much of the recent news was something of a kill or cure tonic for someone like me and there is much for me to get my teeth into. I was deciding between a post on the (very important) consequences of what the US Federal Reserve has just decided to do and the implications of a recent statement by the next Governor of the Bank of England when Standard and Poor’s made up my mind for me! So the UK it is…

What have Standard and Poor’s said?

Standard & Poor’s Ratings Services today revised its outlook on the unsolicited long-term ratings on the United Kingdom to negative from stable. At the same time, we affirmed our ‘AAA/A-1+’ long- and short-term unsolicited sovereign credit ratings.

What does this mean?

It means that all three of the main credit ratings agencies have us on negative watch the consequences of which S&P kindly explain.

The negative outlook reflects our view of a one-in-three chance that we could lower the ratings in the next two years if the U.K.’s economic and fiscal performances weaken beyond our current expectations.

It also means that none of the main credit ratings agencies have the chutzpah to realise that the UK plainly is no longer a nation that deserves a AAA credit rating. Yes we have control of our currency and accordingly can always settle our debts in pounds sterling (freshly printed if need be). However this ignores the fact that these ratings are primarily for foreign investors who would need to transfer any investments out of a possibly depreciated sterling before they can spend/consume it.

Does S&P tell us anything really new?

The basic assessment does not as it is very similar too if marginally more grim than the one outlined last week in the Autumn Statement. However there are some points of note and let me begin with a rather breathtaking one.

along with the U.K.’s good inflation record

Really? Perhaps the word “good” needs to find its way into my financial lexicon..

Also the UK Office of National Statistics produces UK national debt figures which are not comparable to ones used abroad,for example in the Euro area, and the S&P statement highlights this with its numbers.

such slow recovery could result in net general government debt approaching 100% of GDP, by our calculations, from its current estimated level of 85% of GDP in 2012.

If I now give you the latest numbers from the ONS you will get the idea.

Public sector net debt was £1,068.8 billion at the end of October 2012, equivalent to 67.9% of gross domestic product (GDP).

Such differences have tripped up our national broadcaster quite a few times.

Does it matter if we lose our AAA rating?

Whilst there has been a political debate about this issue with both sides using it as a football they can kick, the truth on recent evidence is simply no. If we look back to the recent French downgrade which I discussed on the 22nd of November we see this.

Although the effect has been more perceived that real as the CAC 40 equity index has rallied all week and is now at 3492 and whilst her ten-year bond yield is up to 2.18% that has hardly put it in the stratosphere! Also if we look for international comparisons UK Gilt yields have risen by a similar amount.

So at best not much and if I now update you with the ten-year French bond yield which is 1.98% you can get the full picture. Her benchmark government bonds have risen and yields fallen so exactly the reverse effect that many media pundits will try and have you believe. If we go back to the early part of 2012 we saw a rather similar reaction in the United States govenrment bond market.

In other words on recent evidence the ratings agencies would be doing the UK a favour if they took away our AAA rating! Not quite what many expect is it?

Comparing the UK to France

We can also use the French ten-year bond yield in another way to measure the effect of the UK losing its AAA rating. If we compare her 1.98% to our 1.88% we can see that the gap or “spread” is relatively narrow right now. So an initial perusal might well make one conclude that we might expect our ten-year bond yield to rise by 0.1% and to not exceed 2% which hardly fulfils the claims of some of the doomsayers does it? After all the UK ten-year Gilt yield only passed 2% on the way down in early May of this year so rather than going off the edge of a cliff we would in fact perhaps be stepping back 7 months or so.

Actually markets can be forward thinking

The arguement that the UK losing its AAA credit rating would have a big impact has two other problems. Firstly if you take a look at what the UK Gilt market has been doing in recent times you see that overall it has been falling if we use the ten-year yield as a benchmark. On August the 2nd of this year it closed as low as 1.44% and late August saw another attempt to go lower but early-mid September saw quite a surge which at one point looked in danger of pushing us above 2% again although we only went as high as 1.97% on September 14th. So a more thoughtful reflection would be that if the UK Gilt market had an adjustment to make for the (expected) loss of our AAA rating it did so in early to mid September of this year.

What about Quantitative Easing?

Regular readers will be aware of my theme that due to intervention by both governments and central banks many markets are manipulated these days. The policy of Quantitative Easing or QE is in fact designed to manipulate markets by driving yields lower and prices higher. So far so good for its fans.

However whilst that is true in the initial stages there is some evidence now that once QE reaches the stage that I have described as “More,More,More” then the effect may turn the other way. For example we know this.

In July the MPC announced the purchase of a further £50bn to bring total assets purchases to £375 bn

And we know that every Monday,Tuesday and Wednesday (a new definition of the working week?) when Gilt prices were falling in September the Bank of England was there buying £1,000 million of Gilt stock. Yet my point is that yields still rose and they did so substantially.

Comment

So we see that the real reason why the media will probably not get what it wants when the UK loses its AAA rating is that it happened back in September. If we look at the evidence from recent downgrades we see that in fact one of my favourite economic papers (Rudiger Dorbusch on “overshooting”) may well be in evidence as usually markets then rally. This type of behaviour is summed up in a City phrase which is echoing in my ears as I type this.

Seen it,done it,reversed it

Thank You

It was very kind of all those of you who contacted me about my recent illness with one even  going to the trouble of putting a get well card through my door. As someone who often considers financial tail risk I am left considering health tail risk after stretching and twisting backwards to put up a new light fitting only to discover it has disturbed my inner ear. Anyway there is a musical theme for even this and I now hand over to Elvis Costello and the Attractions.

I can’t stand up for falling down

I can’t stand up for falling down

This entry was posted in General Economics, Gilts, Interest rates, Quantitative Easing and Extraordinary Monetary Measures, Ratings agencies, UK Inflation Prospects and Issues and tagged , . Bookmark the permalink.
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  • John

    Its my personal view that too much notice and importance is given to the ratings agencies. I am far from clear about where their ‘added value’ to the wealth of the nation actually is. What do they contribute that is a real benefit? I would prefer to see their views in the same light as the government takes the views of the man in the street on economic matters – ie. they ignore them.

  • pavlaki

    Welcome back!
    On the previous subject of irrational Eurozone exuberance I see that, following the bank supervision agreement, the media is full of stories along the lines that they can see ‘light at the end of the tunnel’ for the crisis and that the EU leaders are now ‘on top’ of the problem. Have they really read what has been agreed? Only the absolute minimum and Merkel has firmly rejected any major fund for support. Following this ‘spin’ the Euro has soared and bond markets are favourable again. Why? As far as I can see there have been some clever balance sheet shufflings but the debt remains, there is no economic improvement and unemployment continues to increase. Does no one pay any attention to detail any more and only react to spin? Olli Rehn has said that this proves all the Anglo Saxon anti Euro brigade wrong and that the Euro will survive. An interesting if stupid comment as it indicates that somehow they think this Euro crisis is all an ‘anti Euro’ and ‘Anglo / American plot’!! This is not the first time this stupidity has been aired and no doubt not the last. The Eurozone leaders forget that it is in everyone’s interest that the Euro survives but that it order to do so, it probably needs to loose a few members. The Eurocrats may not be good at sorting out the Euro’s problems but they are brilliant at spin!

  • John

    Spin is a good word to use here. Something spinning keeps coming back to the same place, which seems to be what they will do if they don’t form closer political union resulting in unified fiscal and monetary policies for all. In my view, even that won’t sort out the problems, rather it will introduce new ones to the ever growing pile. I have to agree with you in your comments.

  • Anonymous

    Glad to see you back Shaun!

    I am confused about the debt measure you quote S&P asusing. The EU Treaty criteria are for net general government deficit, but gross general government debt. According to Eurostat, the latter measure for the UK was just over 85% in 2011. Is it a coincidence that S&P are estimating net debt at 85% in 2012 and where do they get their estimates from?

  • Rods

    Hi Shaun,

    Good to hear you are back on your feet, I have suffered inner ear problems twice before and it is like being on a ship in a force 10 gale, so you have my sympathies.

    The UK losing its AAA rating will probably have little effect in the short term, where investors are looking for the least worst place to park their money and there are worse places than the UK right now, but market sentiment can change very quickly and when that happens, like it has for Greece, Spain, Italy, Portugal and Ireland when you are running a large deficit then things can start to get very ugly, very quickly.

    The UK failing to get the deficit under control, the debt to GDP approaching or exceeding 100% and / or high inflation could cause this. The response in such a situation will be more QE to cover the deficit, which will increase inflation, so we start of an inflation based economic death spiral. It won’t be like the Eurozone countries where we can print our own currency. But high debts and hyper inflation will lead to the currency being marginalized where foreign currencies like the USD will be used by the population for essentials. At this point the government will have to launch a new currency, which will largely wipe out the UK debts and all savings and fixed incomes in old GBP.

    UK gas and oil through fraking might save us from this fate, but if development is very slow, as expected, then it will be a case of too little too late.

    The alternative is high UK growth saving the economy and reducing our deficit, but with the current public / private sector balance, ever increasing regulation, excessive energy prices due to crazy climate change policies, UK austerity meaning ever increasing government spending and the current tax rates being on the wrong side of the Laffer curve, suggest this is unlikely.

  • John

    May I suggest a different/alternate view?

    The deficit comes from the government spending more than it receives in taxes. The money hasn’t then disappeared, its in the bank accounts of the non-government sector to be spent. It is in the pockets of households, its there for industry to invest. The deficit represents the money that the government has put into the economy; take that away – reduce it to zero for a year – and the resulting depression will cause riots. I don’t want to go there.

    We have a lot of unused resources ready to be employed. Why should there be inflation in these circumstances? Inflation can be imported, I accept that. But at the moment, inflation will come from increasing taxes and industry/utilities increasing their prices without justification of real costs rising. In aggregate, the corporate sector is currently saving and not seeing the point of investing; households are paying down debt; as a result demand is weak. The only sector (as we continue to import more than we export) left to support the economy
    is the government and they are showing by word and actions that they
    do not want to do this. So we are bound to have a weak economy;
    outsiders are bound to see potential problems and query where the
    economy is going to end up – answer – going down as, at the
    sectorial level, no Brits seem to want their economy to succeed. Increased government spending and reduced taxes on a significant scale is needed. And by the way, we don’t need to borrow the money, QE has shown that, and if the dreaded inflation takes off, taxes can then be raised.
    Now I await criticism ………..

  • Anonymous

    Hi John
    I agree entirely. It is another example of a failure not being reformed or corrected as it was the packaging of dodgy mortgage backed securities as AAA bonds which was a major contributor to the current malaise.
    However as I have discussed above markets have pretty much learned the lesson and it is the media and politicians who have been left behind.
    What is missing is any sort of punishment for those who used to run the main ratings agencies as there was clear misrepresentation if not fraud.

  • Anonymous

    Thank you
    I have to confess that my mind has been on another type of spinning this week…
    However the perception of regulation of financial sectors or banks is like one of those oddly declining verbs. It is always welcomed and surprise is then inevitably expressed when it fails! So we are at stage one right now.
    As to the ECB getting the job there is a problem because it is not the central bank in the way that the Bank of England is and it is a relatively recent institution.For example it has never done this on anything like this scale before,what could go wrong?

  • Anonymous

    Hi Ian

    Yes there are as many measures as you can shake a stick at I am afraid…

    I highlighted the ONS/S&P gap because it is substantial as in the range 15-20% of UK GDP. It is also true that the Eurostat and S&P numbers are similar but from a different definition and S&P are taking the IMF style route! Must be fun at the troika meetings for example…..

    The gap is probably smallest in Italy but widest in Japan so lets hope Japan does not join the Euro.

    As to the reason for the gap then the Australian Parliament has done a decent summary if with an Aussie tinge.

    “In terms of measuring public debt (sometimes referred to as national debt) there are two key indicators that analysts focus on. The first is gross debt, which is, essentially, the sum of all interest bearing loans with a specified repayment date. In Australia this is mostly government securities on issue. The other measure is net debt, which is gross debt less financial assets, such as the holdings in the Australian Future Fund. These measures are usually expressed as a percentage of gross domestic product (GDP).

    International comparisons usually focus on gross debt as this is easier to calculate on a comparative basis. A comparison of net debt is much harder due to the way different governments define financial assets. However, analysts at the International Monetary (IMF) have recently calculated estimates for both these indicators for a wide range of countries. It should be noted that most countries in the IMF survey include debt from all levels of government, whereas the Australian data only looks at central government debt.”

  • Anonymous

    Zimbabwe spent more than it earns. The Weimar republic spent more than it earned. Argentina, Bulgaria upto 1996, Greece, Spain etc. There is a reliable historical record of the perils of govt overspending – why should it be different for the UK this time ?

    Secondly, the UK tried to raise taxes in the 70s as recorded in the Beatle’s taxman “19 for me and 1 for you” …. this punitive tax caused a brain drain when the Beatles (and many other wealthy tax payers) left the UK – The Laffer curve theory claims that excessive tax rises do not increase revenue. Monsieur Hollande has inflicted heavy rises on France’s wealthy – what I read in the economist suggests this isn’t going rescue France, but time will tell ….

    Given that tax rises did not work in the 70′s – why do you think they should work this time ?