The Great Risk Game and selective deleverage

The innevitable has happened and US was hit with a gentle credit rating downgrade. I say gentle because the new AA+ status conferred by S&P is still very optimistic. This downgrade should not be too much of a deal, unless the Fed plans to play a ruthless risk game on the global financial markets.

First let's see what this downgrade means for US economy... IMHO it doesn't amount to anything significant. With respect to US bank risk and short term financing (money markets funds and financial paper), SEC is ruling risk assessment by regulation: UST paper has been declared with zero risk.

Foreign central banks accumulate UST paper not as a form of investment or savings but as a residual effect of their Fx intervention. If foreign central banks want to keep their currencies artificially depressed with respect to USD then they have to accumulate US debt, through blatant (like in China's case) or more discrete currency sterilization operations. Of course foreign central banks can choose to convert their USD residual accumulation in some other instrument such as corporate bonds denominated in USD, or state and muni debt. This of course is a joke since UST paper still has the best credit ratings of all USD denominated debt instruments.

I believe the ones which are going to be hit by this downgrade are the global SWF and private fixed income entities. Also foreign financial entities holding collateral in UST paper are going to suffer. The next question is where to run for safety?

One of the options would be PM's but the gold and silver markets are so heavily manipulated by central banks and a few vampire squids that no sane financial manager can think of a major portfolio allocation in gold and silver.

The Eurozone is ailing and with the looming threat of having Italy going the Greek way, the EU stabilization fund definitely cannot cope with such a crisis. It would be funny to see a major move in Tsy paper with an sudden and artificial steepening of the yield curve, with T-bills and even 2-yr flooring or going negative while the 20 and 30 yr exploding. This would be a natural move since a dive of USD on Fx markets is inevitable. One may think that the Fed may not be interested in setting up a new Operation Twist if they can keep the short term yields close to zero.

China has started the usual posturing show, saying that the "good old days of borrowing are over" for US. I believe this statement is correct, but the funny part is that those "good old days" of borrowing for USA were also the "good old days" for export and over-investment based development in China. If the Chinese government wants to see USA embarked on a sound fiscal regime all what they have to do is to set the yuan free to raise to its true potential. :)

In a way the strange coincidence between the US downgrade and the Euro crisis, creates an unique opportunity to have a coordinated devaluation of the USD-EUR construct, which will reverse the global capital flows, creating an influx of cheap capital into US (and partially EU economies). Naturally, smaller partners like the Swiss will have to resort to brutal Fx interventions (like the Swiss have already done it) in order to prevent their currencies from soaring, and they can do that very simple by currency sterilizations performed directly through the swap lines offered generously by the Fed.

With the "good old days of borrowing" being over, we may see a return of the "good old days" of overseas capital influxes and cheap domestic credit returning to US. If the Fed will be able to keep the housing situation under relative control, all the toxic mortgage paper from the 2008 crisis will be brought from underwater levels at least to the floating line. Meanwhile asset bubbles will collapse all over Asia and in so called emerging markets.

The sign that this global reversal in capital flows has began to take place will be a sudden appreciation of the yuan right after a sudden drop in the gold prices (silver prices may experience a dive too but that is not a given) . If that happens we will know that Warren Buffet has been right once again with his strange bet on the domestic US economy.

However before getting to that point we have to go through the birth pain of the new global regime which will be quite similar to the global economic system before 1996. We will see the US stock markets taking a hit, to more reasonable P/E ratios, PM soaring and all that jazz.

As Rahm Emanuel has said one should never let a good crisis go to waste.