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Brexit: does the market even care about AAA anymore?

Back in the early 1990s the growing size and volatility of the FX market became an increasing concern of regulators as more and more participants began trading in larger size.

" If the market keeps buying the bonds anyway, what is the point of worrying about what the ratings agencies say?"
Sean Keane, Founder & Managing Director, Triple T Consulting

Industry organisations such as the ACI were asked to assist in developing training techniques and programs for young traders, to improve their skills. The foreign exchange dealing game emerged at that time as a way to develop risk management and trading skills as news was released to the ‘market’ the game took place in, and traders responded by adjusting their positions.

Usually in these games ‘the market’ traded in a range, then trended and was hit with a planned shock event. Young traders everywhere learned a sovereign downgrade should be treated as a market negative for whatever country was named, and the currency and the sovereign bonds of the affected country should be sold aggressively.

Reacting to this game event quickly usually won the FX game for the quickest participant. The simple lessons learned from these games served generations of traders for most of their careers, but in the world of QE and QQE they appear to have little meaning.

DOWNGRADE

Following the Brexit vote the UK’s credit rating was immediately the subject of market speculation, and on Monday Fitch downgraded the United Kingdom’s rating, as did Standard & Poor’s.

The S&P action was a two-notch downgrade to AA from AAA, an act which removed the countries last claim to be a AAA credit. (The other agencies had lowered the rating some years ago). The Fitch downgrade was to AA from AA+, with both rating agencies warning further downgrades were possible.

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The remarkable thing about this is instead of dumping UK bonds and currency the market has driven 10-year gilt yields below 1 per cent for the first time in recorded history and the Sterling has resolutely rejected the 1.3000 level against the US dollar before recovering quite well, under the circumstances. It is certainly acknowledged part of GBP/USD fall could have had a ratings risk adjustment included in.

The question therefore might reasonably be asked: what relevance do sovereign ratings really have to market prices in the current era, given demand continues to exceed sovereign bond supply in many markets, regardless of the rating the bonds carry?

This is obviously relevant for the UK at the current time, but it is also particularly relevant for countries such as Australia where the Reserve Bank and the market have indicated additional fiscal support is preferable to more monetary policy stimulus.

That preference has generally been rejected in Canberra on the basis additional debt issuance might place Australia’s hard-won AAA rating in danger. The same question might reasonably now be posed downunder: “So what if Australia loses its AAA rating? If the market keeps buying the bonds anyway, what is the point of worrying about what the ratings agencies say?”

OVERSIMPLIFICATION

Such arguments obviously oversimplify the issue. They ignore concerns about maturities and new issuance, and they ignore the potential problems that may be faced by the Australian State government issuers, and the impact on non-government corporate credits. Each of these will be affected differently by the loss of the AAA rating.

Despite that, defence of the AAA rating as a powerful argument against fiscal expansion is no longer as potent as it once was. The post-crisis market has certainly paid less heed to ratings than it did before and end investors are less accepting of the rating as the only determinant of risk.

The other important change is the global squeeze on fixed income assets, and most especially on government bonds, has meant supply, coupon and availability all now rank above the rating in the minds of many buyers of government bonds.

Another good example of the squeeze-in is being seen in government bonds globally is the relentless rally taking place in New Zealand. New Zealand’s generic ten-year government bond yield has fallen approximately 125 basis points this calendar year, and by 62 basis points this quarter.

The current implied rate at the close today was just above 2.30 per cent. That yield is just 30 basis points above the middle of the RBNZ’s inflation target band, which it is mandated to reach over the medium term.

Assuming investors have faith in the RBNZ’s ability to achieve its mandate over the future period the current bond yield is thus guaranteeing a real return very close to zero.

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In many parts of the negative world a guaranteed zero real return looks remarkably good at present, especially for the Japanese and Swiss with their deep negative rates.

Few managers or advisors in New Zealand appear to be recommending accumulation of local government bonds at such record low yields however, and some might be inclined to lighten their holdings and look for opportunities elsewhere.

That theory is easier to talk about than to practice however. Many life insurance and long dated asset managers are increasingly being forced into the market to bolster their long term solvency position by ensuring a guaranteed level of minimum return.

Many of these buyers don’t necessarily want to buy government bonds at such low yields, but they have little choice but to do so given narrow investment mandates and their prescriptive actuarial requirements.

This piece was originally written by Sean Keane of Triple T Consulting for Credit Suisse and is reproduced with their permission.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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