Market view of debt more important than credit ratings: report
How investors trade U.S. Treasuries in case of a U.S. credit rating downgrade will depend less on the ratings move itself and more on the long-term inflation outlook, Bank of America Merrill Lynch strategists said on Tuesday.
The Treasury has set August 2 as the date when it will have exhausted all of its emergency measures to avoid default. The Obama Administration and Congress have not yet agreed to raise the $14.3 trillion limit on how much the government can borrow.
Credit rating agencies Standard & Poor's, Moody's Investors Service and Fitch Ratings have all voiced concern over the U.S. debt rating in the absence of a long-term plan to put the country on a long-term sustainable fiscal path.
The AAA credit rating for the world's largest economy has symbolic value. But Jeffrey Rosenberg, head of global credit strategy at Bank of America Merrill Lynch, said markets would assess for themselves the U.S. ability to make timely payments on principal and interest.
The market makes its assessment of price, (of) yield, based on its own assessment, not that of the ratings agencies, he told reporters during a mid-year outlook briefing.
The long-term credit risk in the United States -- not the debt ceiling debate that we are having now -- is really inflation risk. What you see in the market is, there is not a lot of inflation risk concern today, said Rosenberg.
In mid-April, Rosenberg became one of the few mainstream credit strategists to suggest there may be a case for the U.S. to allow a temporary default on its debt.
His April 18 report said a temporary suspension of debt payments as the cost of achieving a political compromise that brings long-term fiscal sustainability may lead to greater long-term financial benefits such as declining relative long-term interest rates.
That view has gained some cachet in Washington, where some Republicans have latched onto the idea of a brief default in order to force the Obama Administration to accept deeper spending cuts in return for a higher debt ceiling and ultimately a budget compromise.
Nevertheless, BAML expects yields on benchmark 10-year U.S. Treasuries to end the year at 3.60 percent, lower than the 4.0 percent forecast given at the start of the year.
Ethan Harris, head of developed markets economic research, said he expects a very last minute decision on the (U.S.) debt ceiling.
In the context of the political debate over raising the debt ceiling, a move by the ratings agencies would throw a little gasoline on the fire, he said.
Harris said with Japan's economy coming back from its natural and nuclear disasters and an expectation that oil prices will drop, the remaining bomb waiting out there is the debt ceiling debate.
In the negotiations dubbed the fiscal follies, the two sides could do nothing and trigger a TARP moment in which violent market movements would compel a set of actions.
Another scenario could be comprised of modest up-front cuts in the debt and a two-year debt ceiling extension, a scenario that could end the economy's soft patch, he said.
With the economy fragile, big upfront cuts in the federal budget would torpedo growth, Harris said.
He told Reuters that the current outlook for the U.S. economy in the second quarter is running behind Bank of America Merrill Lynch's 2 percent growth forecast.
We have it at 1.7 percent for the second quarter, based on the latest batch of economic data. But we have not changed the official forecast of 2 percent, set months ago, Harris said, adding that he does not expect the Fed to start raising interest rates until at least September 2012.
The firm forecasts GDP growth of 2.4 percent this year and a 10-year Treasury yield of 3.6 percent by year-end. The growth rate for 2012 edges up to 3.0 percent.
Despite this subdued growth, chances for increased monetary stimulus remain slim, the strategists said.
Francisco Blanch, head of commodities research, said the firm does not think a third phase of monetary stimulus through large-scale asset purchases is likely.
For gold to get back to that $2,000 range-plus, you are going to need QE3, and right now we don't think QE3 is in the cards, which is the reason we have become a little bit more cautious in terms of the gold outlook, said Blanch.
The firm has a $1,650 per ounce cyclical peak in gold prices, although commodity markets will remain volatile.
David Bianco, head of U.S. equity strategy, stuck with his year-end target of 1,400 on the benchmark Standard & Poor's 500 stock index, but reiterated that it could go as high as 1,500.
Bianco has technology stocks as an overweight in the firm's asset allocation model. Industrials, consumer staples, materials, financials, energy, consumer discretionary and health care are at equal weight. The underweight sector is utilities and telecommunications.
Turning to Europe's debt crisis, Rosenberg said risks in the credit markets surrounding Greece's current problems were less of a crisis in this go-round when viewed in the context of the past financial market crises over the last 4-1/2 years.
Paresh Upadhyaya, head of Americas G10 FX strategy, believes the market is fixating too much on Greece, and said the bigger risk is for contagion to spread to Spain.
He expects Greece's parliament to pass the next round of proposed austerity measures this week, but said that nation's fiscal situation remains far from settled.
I'm afraid Greece becomes a Ground Hog Day. It will not quite disappear.
(Reporting by Daniel Bases and Ellen Freilich; Editing by Dan Grebler)
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