Stocks sell off as S&P cuts US outlook; Does a drop in foreign demand for Canadian bonds signal rising fixed interest rates?; Greek restructuring would be “catastrophic”

Stocks sell off as S&P cuts US outlook

Big news of the day is the downgrade in the US outlook by rating giant Standard and Poor’s.  There can’t possibly be too many analysts who don’t see storm clouds on the horizon for the US  considering their massive and growing debt levels, huge unfunded liabilities, and almost complete lack of political will to deal with these problems.  Yet the market seems to have received this news as some sort of new and shocking revelation.

From S&P:

“Because the U.S. has, relative to its ‘AAA’ peers, what we consider to be very large budget deficits and rising government indebtedness and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable.”

Perhaps the more significant bit of news is this statement from S&P:

“The negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years.”

More than the downgrade itself, this statement is likely what has the markets jittery.  A downgrade of the United States’ credit rating would have significant repercussions on the treasury market and interest rates.  Many money market funds and other mutual funds have stated limits in terms of the percentage of their holdings held in AAA rated sovereign bonds.  Should the US lose that hallowed status, it would result in the forced selling of treasuries by many funds.  It would also eliminate a portion of the demand both domestically and abroad.  The end result would be higher interest rates on US bonds which would be passed on to consumers in the form of higher mortgage rates.

Foreign demand for Canadian bonds drops

Stats Canada today released the international transaction in securities for February 2011.  Two trends are worth noting:

1)  Foreigners were net sellers of Canadian bonds in February for the first time since late 2008!  Foreigners sold $5.0 billion in federal bonds.

One has to wonder if this net selling in bonds was partly the cause of the jump in interest rates on the 5 year GoC bond in February.

Demand for the 5 year Government of Canada bond is extremely important as it determines interest rates on 5 year fixed mortgages.  Perhaps more importantly, it helps to set the qualifying rate which is now used to assess the maximum mortgage amount an applicant qualifies for when seeking a variable rate mortgage.  This is why I recently suggested that because because of these new rule changes, the housing market is increasingly at the mercy of the bond market (over which the Bank of Canada has little control).

While I suspect that this reading is not the start of a new trend, particularly in light of the S&P announcement today which will drive more capital into the true AAA countries, it certainly highlights how fickle the bond market can be, and in turn, how at risk the housing market is to swings in mood by bond investors.

2)  The second trend worth noting is the rise in Canadian stock purchases by foreigners.  Total purchases amounted to $4.9 billion, the highest since May of last year.  This has no doubt helped buoy the TSX.  The ongoing rise in commodity prices no doubt led many investors to seek out Canadian resource companiesIt’s getting increasingly difficult to find bargain stocks on the TSX, particularly in the more popular resource space, though there are still a handful of well priced resource companies with strong balance sheets and reasonable valuations.

Greek restructuring would be “Catastrophic”

The near-certainty of a Greek debt restructuring has analysts chiming in on the potential implications.  For those unfamiliar with the term, a restructuring typically involves the creditors of a nation accepting less than what they were promised to be repaid.  A simple example of a restructuring is if I owed you $100 but couldn’t afford to repay it.  Instead I offered you $80 (with the alternative being that I declare bankruptcy and you get nothing).  That’s the idea.

However, as I suggested in an earlier post, restructuring has the potential to create a European financial crisis as many of the big banks are holding Greek sovereign debt.  If they suddenly face a loss of their capital, they may be in trouble.

Now the Bank of Greece Governor George Provopoulos has suggested that such a restructuring is not needed (yeah right!) and would be catastrophic.

From the Globe and Mail:

A Greek debt restructuring is not needed and would be catastrophic for the country, hitting bank and pension fund assets and closing off access to capital markets, the head of its central bank said on Monday.

“The Bank of Greece has explained with clarity since last October that such a (restructuring) option is not necessary, nor desirable,” Bank of Greece Governor George Provopoulos said in a report to shareholders.

“It would have catastrophic consequences.”

A finance ministry official earlier denied a Greek media report the country had already requested restructuring talks with the EU and IMF.

Yet another sign that Europe is falling apart at the seams under the weight of the debt woes in its peripheral countries.  The threat of a break up of the monetary union cannot be ruled out, particularly after the results of the Finnish election over the weekend saw the True Finns party, which ran on an openly anti-bailout platform, garner 19% of the votes, a 15% jump over the last election.  Mike Shedlock made an interesting post on this.



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20 Responses to Stocks sell off as S&P cuts US outlook; Does a drop in foreign demand for Canadian bonds signal rising fixed interest rates?; Greek restructuring would be “catastrophic”

  1. UnagiDon says:

    My favorite scene from “Inside Job” was when the rating agency executives were testifying and they stated that their ratings have no bearing on reality; they are simply opinions. Yet people still give credence to S&P ratings.

  2. John in Ottawa says:

    Yes, this rating brought to us by the same people who rated toxic MBS AAA for years. We should believe, then, that US Treasuries are junk bonds.

    The move from bonds to equities in February signals a belief in a strengthening of the Canadian economy, not a lack of faith in Canadian bonds. Just moving funds to where the best return can be made. This creates only a minor move in interest rates.

    What did Greek ten year bonds sell at today? 13%? There is still a ton of entertainment value in the European saga.

    Say, what did you folks make of Garth Turner’s advice today? Should we Boomers move our house equity into the bond and equity markets? Talk about your stimulus! That would be more stimulus than most of us have had in years. How come this guy isn’t running for Prime Minister?

    • jesse says:

      A couple of commentators opined the best way for the US to rein in its deficit is for the government to shut down for a while. S&P is simply worried the government will be unable to raise adequate revenue to fund its obligations. Their point is simple: something has to give — spending must be curtailed or taxes must be raised — and continuing to pass interim budgets like the last one is no long-term solution.

      Canada faced its Waterloo on this front 20 years ago, facing similar threats from ratings agencies in the face of rising deficits and a perceived inability of the government to raise funds by raising taxes. In the end Canada won that battle, not least by both raising taxes and cutting government spending in the ’90s.

  3. Who knew Obama had a comedian as an economic advisor:

    “The White House on Monday dismissed ratings agency S&P’s decision to downgrade the outlook for the United States as a “political judgment” and said progress had been made toward deficit reduction.”

    ….Yes….progress has been made alright….

  4. Ahsan Zaman says:

    Quick question. What are the implications of the US downgrade for Canada?

    • Hard to say. Certainly lower bond yields relative to US (absent QE3,4,5,6,n), higher currency, economic outperformance relative to US, CPI inflation remaining tame, etc.

    • John in Ottawa says:

      The Fed will move heaven and earth to avoid it, but it is becoming increasingly likely the US will enter another recession later this year. If the US enters recession, we will follow to some degree.

      A downgraded US coupled with a relatively strong Canadian economy will make Canadian assets more attractive, adding to the Loonie’s value. A strong Loonie is nice when we go shopping abroad, but it creates problems when we try to sell abroad.

      Downgrading US debt isn’t quite the same as downgrading Ireland or Portugal. The US dollar is still the reserve currency, so they still have some breathing room. I think though, this would be a good time to dust off our history books and read about the end of the British Empire. We’ll probably find some parallels going forward.

      Oh, and I got the Greek number completely wrong. The two year bond went for more than 20%. Effectively, they are priced (locked) out of the market.

      It was 40 years ago that my father-in-law told me that when the government could no longer pay its benefit obligations there would be rioting in the streets. Start writing down 70-80% of Greek pension obligations and the riots we have seen so far will look like Sunday picnics.

  5. Ahsan Zaman says:

    Today’s press release. The softening in sales appears to have been temporary. The housing market is taking off again! Only this time there isnt any inventory.

    Click to access nr_mid_month_0411.pdf

    • jesse says:

      Carney’s not going to like that… methinks Flats is going to have a message on his machine when he gets back to the office in May.

      • Ahsan Zaman says:

        Funny you should say that. I have noticed how the real estate industry has softened its blustery tone about the market taking off. All of a sudden we are seeing numbers excluding Vancouver to make things not look as rosy. Even R le page is talking about prices flattening out. They are the most blustery of the lot.

        I think that they know that once the election is over someone is going to do something to turn the taps off if things look over heated.

      • If the conservatives get a majority, I wouldn’t be surprised to see further mortgage tightening and a possible revision to the 5% downpayment.

      • Ahsan Zaman says:

        April is also likely the last month of sales declines (only 3% so far!!!) . May onwards the comparable year ago number is when sales plummeted with mortgage rule changes. We will likely start to see sales grow again versus previous year May onwards. Added to that if this inventory trend persists, prices will be through the roof.

        It all means that the inevitable drop will be that much larger and harder.

    • Wow! That is impressive…..21% drop in inventory and only 3% drop in sales??? Could spell the return of the wide spread bidding war by the summer if things don’t settle.

      • Ahsan Zaman says:

        Definitely seeing the bidding wars in my neighbourhood- Beaches, Toronto. Yesterday I saw 3 “over asking” sold signs.

    • Ahsan Zaman says:

      I posted this over chez Garth Turner. I have been saying on his site for some time that declining sales is not the big story- declining inventory is. I posted this press release on his site today. Not only did he not post the link, he has removed my ability to post to his site anymore!

  6. ridiculous says:

    There are and will always be dishonest & self interested people in the world – operating under the assumption that these people don’t exist is naiive. This is why we have auditors – to provide third party assurance as to the quality of the information being presented to us.

    The bond rating failure is in my opinion the single biggest cause of the global financial crisis. If those bonds had been rated correctly, no one would have loaned anyone any money without understanding the risks of doing so and would have required an appropriate return. Many mortgages would not have been made, many securities would have been unsaleable due to high yield requirements and the subprime MBS market would have never got off the ground.

    Given their failure to properly do their jobs and the resultant gross violation of the public trust, every single one of the bond rating agencies should be sued out of existence – their business model has failed the people they once sought to protect.

    I worked as an auditor for 7 years. The investors of many public companies relied on me for my opinon and made investment decisions based on that opinion – if I was wrong, I got sued. Fortunately, the threat of financially disastrous investor retribution required that I DO MY JOB and I was never sued.

    If the bond rating agencies have such a hard time remaining impartial, maybe their opinions should be audited. Costs would go up but at least the bond rating agencies would need to actually do their jobs and investors would understand what the risk profile of the borrower is.

  7. jesse says:

    On Greece it looks like they will, at least in part, choose the duration extension gambit to “default” on their debt. Now it’s up to the bondholders’ accountants to figure out how to hide the junk.

    I was expecting a bit more creativity but the fat lady hasn’t sung yet! They should take John’s suggestion to heart and swap the bonds into common shares in soon-to-be-privatized SOEs.

  8. John in Ottawa says:

    Nasty inflation numbers today. May give Carney an excuse to tap on the brakes just a bit come May 2nd.

  9. Pingback: Inflation tops expectations… a rate hike now all but assured?; Will Canada be ‘going dutch’? | Financial Insights

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