Tough love on the way for the USA

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The situation has moved from tragedy to farce in the US as the Republicans are fighting among themselves and the vote that was due last night on their package was delayed once again.   It’s now pretty obvious that any deal that eventually emerges is going to be primarily driven by political compromise, rather than be structured to tackle the longer-term issues on the US budget.  

This makes a downgrade by one of the major ratings agencies pretty certain.  Markets are moving to accept this view, which is not proving to be as negative for the dollar and also US bond markets as many had feared.  The dollar index has risen for the past two sessions and also overnight, in part thanks to the weaker tone to the euro.  Meanwhile, 5Y CDS on the US has risen by more than 10bp over the past week, up to 64bp by yesterday.

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Commentary

Spain put on ratings watch.  The ratings agencies feel like the new masters of the universe, with pronouncements on a near daily basis with regards to sovereign nations.  Moody’s is the latest, with its pronouncement this morning that Spain is being put on ratings watch with a view to a possible downgrade.  Currently at Aa2, they cite the continued funding pressures and, reading between the lines, possible contagion in the wake of the new Greek package.  They also highlight weak growth making it more difficult for the government to raise the required revenues.

UK consumer confidence falling once again.  No great surprise to see another fall in UK consumer confidence data overnight, down to -30 from -25 in June.  Consumers were far more bearish on the outlook for the economy over the coming year.  After the latest GDP data, the government is likely to fall short of its growth expectations published in the budget back in March (economy seen growing 1.7%).

Back to euro bashing again. The euro was again under pressure Thursday, as was the case late Wednesday. There was no specific factor behind the move but what does seem to be the case is that investors are now resigned to the fact that a deal on the US debt ceiling is unlikely to be in place by the August 2nd deadline.  Furthermore, there is growing confidence that this may not be that dollar-negative (or may even be dollar-positive).  This sense of resignation has also focused attention back onto the euro and the continuing issues that lie beneath. There were rumours that the Italian finance minister was close to resigning, but this would be no great surprise given the division that has emerged between him and Berlusconi.  In the background, the fact that S&P has downgraded Greece again is of no real significance, but what was notable was S&P’s confirmation that the implementation of the Greek plan announced last week would amount to a partial default. There is also now talk that Cyprus may need some assistance, with growth set to soften this year and Moody’s having cut its debt rating to two notches above junk. The break was brief, but it appears that we may be back to euro-bashing once again.

Swiss franc will just have to roll with it. Despite the sharp appreciation and new record highs vs. the euro, the Swiss National Bank (SNB) has not attempted to quell this rise by intervening to sell francs. The Swiss stock exchange is down 8% (one of the weakest performers in Europe) and Swiss companies are now becoming more vocal, with Swatch yesterday citing the impact of “uncurbed speculation” on the franc impacting profits. This could easily be interpreted as a veiled warning to the authorities to act. The SNB has the strength of its balance sheet in its favour, with reserves some 50% of GDP versus 10% in the early part of 2009. However, the SNB probably feels it would be fighting a losing battle in the current environment. When the dust settles after the US debt ceiling negotiations, and investors start putting their idle cash to work, the risk is that they may more actively avoid currencies where sovereign risks are looming. If this is the case, then the Swiss franc may find that its safe-haven appeal remains in place. The SNB may then have a fight on its hands in the face of these new global forces.

Markets resigned to debt ceiling failure. A downgrade is looking ever more likely, not on the default issue (they still may stitch something together to avoid this), but on the inability of the political process in the US to tackle the longer-term budget issues in the fashion required. Don’t forget that the debt ceiling was raised eight times during the Bush presidency and, as the independent Congressional Budget Office has pointed out in its latest report, “the growing debt also reflects an imbalance between spending and revenues that predated the recession”. In other words, the issue of rising debt transcends the political divide in the US, but lawmakers appear to be missing this point entirely as they consider their own re-election chances.

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