What Prompted The S&P Downgrade And What's Coming Next

Convergence of Trouble 
The Week Ahead Section of Stock World Weekly

Monday’s announcement by Standard & Poor’s that it was downgrading its outlook for the United States from stable to negative shook up the markets, attracting ample attention from analysts openly wondering what it was that sparked this particular action at this particular time.

Dave Lindorff of the blog “This Can’t Be Happening” wrote, “At least one economist burst out laughing on hearing about the S&P announcement. ‘They did what?’ exclaimed James Galbraith, a professor of economics at the University of Texas in Austin, who formerly served as executive director of the Congressional Joint Economic Committee. ‘This is remarkable! It certainly will confirm the suspicions of those who have questioned S&P’s competence after its performance on the mortgage debacle.’ S&P, as well as the other two big ratings firms, all notoriously failed completely to spot the looming disaster of the banking collapse and financial crisis, and famously issued A ratings to mortgage-backed securities that later proved to be virtually worthless paper, as well as to the banks that had loaded up on the financial dreck.”

So what prompted Standard & Poor’s to issue this downgrade? Lindorff offers two possibilities: “Either S&P has been pressured by powerful Republicans and/or Wall Street Bankers to issue this warning, in order to add to national hysteria about the national debt and win more drastic cuts in social programs, or S&P is simply blowing it again.” 

James Galbraith noted “Political shenanigans cannot be ruled out, that’s what lawyers would call the ‘rebuttable presumption.’ After all, who benefits? The Republicans and perhaps the banks. But of course the other possibility is that S&P doesn’t know what it’s talking about, and after their disastrous missing of the mortgage bubble, that’s quite possibly what it is.” (An ‘Oh Please!’ Moment: Is S&P running interference for the Right to Help Crush Social Security and Medicare?)

Lee Adler of The Wall Street Examiner wrote last week, “The market sailed through a week of light Treasury supply with reduced POMO support. A big Treasury paydown this week put extra cash in dealer trading accounts and it did exactly what we expected it to. S&P threw a little glitch into things on Monday by putting the US on a negative watch. They probably just had a big client with a huge buy order outstanding. A little negative news and Voila! Done!

Next week, Lee thinks, will be a little more interesting. “POMO will be insufficient to absorb $52 billion in new supply. With that much paper to sell, the government will want to see yields lower. So be on the lookout for a 3 AM stock futures selloff in the pre market probably Tuesday and/or Wednesday. There’s nothing like a little stock market liquidation to get a buying panic going in Treasuries. If that doesn’t happen, then something will need to take a hit around May 2. That’s settlement day for $45 billion in new notes. We would need to keep an eye on the technicals for clues to which market would bear the brunt of that if there’s no pre auction liquidation of stocks.” (The Wall Street Examiner, subscription required) 

Quantitative easing (QE2) is scheduled to expire at the end of June. In a recent interview with Jon Hilsenrath of the Wall Street Journal, Fed Chairman Ben Bernanke indicated that QE will not be pursued once the current program runs its course. In an interview with John Nyaradi of Wall Street Sector Selector, Phil pointed out that this is not actually the case. “QE2 isn’t going to end. This is a misnomer about QE2 because what’s going to end is the new funding. About 50% of what’s going in from the Fed now is rollover money… (The Fed) is buying 85% of the Treasury notes. They can’t stop. How could they stop? Who’s going to buy?”

When QE2 was announced, the budget for the program was set at $600Bn plus additional funds made available by reinvesting principal payments from agency debt and agency mortgage-backed securities. Those additional funds boosted the total budget for QE2 to somewhere between $850Bn to $900Bn. In other words, the Fed had between $250Bn and $300Bn available to use for buying Treasuries during QE2, funds made available from the performance of assets it owned at that time. Imagine how much more could be available to the Fed once it has completed purchasing another $850Bn to $900Bn worth of assets by the end of June?

So where does this end? In Phil’s opinion, it will eventually end in hyperinflation. “There’s no end game to what we’re doing other than hyperinflation because we have to pay off our debt ultimately. Look at how ridiculous it is. We owe $15 trillion. And we go another $1.5 trillion into debt every year.” There’s no chance to pay off a $15 trillion dollar debt by adding another $1.5 trillion in debt each year. At this rate, in 10 years, we’ll owe $30 trillion. 

According to Phil, “There’s no realistic way to pay off this debt other than gross inflation. That means we need inflation, and it has to be hyperinflation because the inflation has to occur faster than our debts are mounting.” So we have to grow the GDP so fast through inflation that it dwarfs the rising interest rates on the debt that we have. Then, with devalued Dollars, “we may be able to start making some payments.” (Phil Davis Discusses Options and Today’s Markets)

Jesse, at Jesse’s Cafe Americain argues that many years of stagflation is a likely outcome of the Fed’s ‘managed inflation’ policy. “The problem or twist this time around comes when the monetary stimulus does not increase jobs and the median wages, because of some inherent and unreformed tendency in the economy to focus money creation and its benefits to a narrow portion of the populace. The result of this is stagflation which although not indefinitely sustainable can be maintained for decades.” Whatever the flationary route, Jesse concludes, “the reissue of the dollar with a few zeros gone is inevitable.

This week’s newsletter trade idea comes from Pharmboy,… read on.  

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