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Lea Jakobiak
On the eve of a keynote speech by the ECB President, Mario Draghi, one leading economist doesn't hold back in the way he believes the Bank has dealt with the eurozone's faltering recovery.
Article / 06 August 2011 at 13:33 GMT

Crisis 2.0 is here; USD and bonds to suffer most from downgrade

Steen Jakobsen Steen Jakobsen
Chief Economist & CIO / Saxo Bank
Denmark

The impact of the Standard & Poor's downgrade of the U.S. credit rating is very hard to gauge for several reasons which are outlined below:

  • It was rumoured all afternoon Friday and was the reason for the early evening sell-off in the S&P 500. The downgrade seems to have been known to major insiders ahead of time.
     
  • The timing is very unfortunate, coming outside trading hours and therefore leaving investors nervous ahead of the Asian open on Monday.
     
  • There is an increased probability of some kind of coordinated policy response over the weekend - as even before the U.S. downgrade this was already the worst week for risk since the 2008 financial crisis.
     
  • Pain will most logically be felt in U.S. fixed income, as U.S. bonds are used extensively as collateral in guaranteed capital structures, and with this downgrade some of these structures could be deemed invalid and as such create the need for selling fixed income into the market. There are few managers demanding AAA rating for their portfolios but net net we will most likelt see higher U.S. yields. One must also remember that U.S. yields are extremely low - i.e bonds are high in price already.
  • The U.S. dollar should open lower but this could be the final weakening of the U.S. dollar as I firmly believe the U.S. will be competititive with China within the next two to three years. This is primarily because years of weak U.S. dollar policy, huge free capacity and local states eager to subsidise job creation through tax discounts will make the U.S. an appealing alternative to production in Asia. The EUR versus USD should open higher if only because focus shifts from the EU debt crisis to the U.S. at least for the next 48 hours of trading.
     
  • The U.S. stock market should, at least theoretically, see the least impact as this concerns the financing of government debt, not private debt. U.S. corporations are in a much better situation than in 2008 as they have used years of low yields to refinance and put their balance sheets in order, but there is obviously a psychological impact as we trade on lows for this year and everyone's nerves are fragile.
     
  • This is clearly a confirmation of Crisis 2.0 as the U.S. downgrade makes this an issue of financing governments. The policy makers are now paying the price for their failed experiment of buying time. That price is ever higher yields and ever higher budget deficits (due to increased debt servicing).
  • This next phase will be one of extreme volatilty and lack of transparency - the Maximum Uncertainty scenario from our latest Quarterly Outlook.
  • After the initial impact from the U.S. downgrade, we will see policy responses which could, and I mean could, see a move up in risk again based on hope, but hope belongs in prayers not in markets, and we may have seen the top of what historically will be seen as a major bear market rally of below the March 2009 low (S&P at 666)

Welcome to the official Crisis 2.0 which is now in progress!

 

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