Dow flat on Moody downgrade and Gaza war ceasefire suspense

On Friday, Wall Street was boosted by hopes of good relations between the US and China (positive for US MNCs and techs) and a Gaza war ceasefire (from a 4-hr pause to a 3-day ceasefire) coupled with less hawkish Fed talks. U.S. bonds slip again as a result of subdued demand and higher supplies coupled with ICBC ransomware disruption. Gold slid amid lower bonds and ease of Gaza war tensions.

But Late Friday, Dow Future also slipped to some extent (after the closure of the spot market) as Moody’s cut the outlook of US debt from positive to negative amid higher borrowing costs and surging fiscal deficits.

Moody’s said:

·         Changes outlook on United States' ratings to negative

·         Downside risks to the US fiscal strength have increased

·         The US fiscal deficits will remain very large

·         Debt affordability in the US to be significantly weakened

·         The US' long-term local- and foreign-currency country ceilings remain unchanged at AAA

·         Absent policy action fiscal strength will decline

·         Political polarization exacerbates fiscal risks

Relevant text of Moody’s report: Moody's changes outlook on United States' ratings to negative, affirms Aaa ratings

“Moody's Investors Service (Moody's) has today changed the outlook on the Government of United States of America's (US) ratings to negative from stable and affirmed the long-term issuer and senior unsecured ratings at Aaa. 

The key driver of the outlook change to negative is Moody's assessment that the downside risks to the US fiscal strength have increased and may no longer be fully offset by the sovereign's unique credit strengths. In the context of higher interest rates, without effective fiscal policy measures to reduce government spending or increase revenues, Moody's expects that the US' fiscal deficits will remain very large, significantly weakening debt affordability. Continued political polarization within US Congress raises the risk that successive governments will not be able to reach a consensus on a fiscal plan to slow the decline in debt affordability.

The affirmation of the Aaa ratings reflects Moody's view that the US' formidable credit strengths continue to preserve the sovereign's credit profile. First, Moody's expects the US to retain its exceptional economic strength. Further positive growth surprises over the medium term could at least slow the deterioration in debt affordability.

Second, the US' institutional and governance strength is also very high, supported in particular by monetary and macroeconomic policy effectiveness. While the adjustment of the US economy and financial sector to higher-for-longer interest rates is underway, policymakers have facilitated the transition through transparent and effective policy.

Finally, the unique and central roles of the US dollar and Treasury bond market in the global financial system provide extraordinary funding capacity and significantly reduce the risk of a sudden spiraling of funding costs, which is particularly relevant in the context of high debt levels and weakening debt affordability.

The US' long-term local- and foreign-currency country ceilings remain unchanged at Aaa. The Aaa local currency ceiling reflects a small government footprint in the economy, relatively predictable and reliable institutions, very low external imbalances and moderate political risks, all of which reduce the risks posed to non-government issuers by government actions or shocks that would commonly affect the government and the private sector. The foreign-currency ceiling at Aaa reflects the country's strong policy effectiveness and open capital account which reduce transfer and convertibility risks to minimal levels.

RATING RATIONALE

RATIONALE FOR OUTLOOK CHANGE TO NEGATIVE FROM STABLE

ABSENT POLICY ACTION, FISCAL STRENGTH WILL DECLINE

The sharp rise in US Treasury bond yields this year has increased pre-existing pressure on US debt affordability. In the absence of policy action, Moody's expects the US' debt affordability to decline further, steadily and significantly, to very weak levels compared to other highly-rated sovereigns, which may offset the sovereign's credit strengths explained below.

Past increases in interest rates by the Federal Reserve will continue to drive the US government's interest bill higher over the next few years. Meanwhile, although the government's revenue base will rise in line with the economy as a whole, in the absence of specific policy action, this will occur at a much slower pace than the rise in interest payments.

Moody's expects federal interest payments relative to revenue and GDP to rise to around 26% and 4.5% by 2033, respectively, from 9.7% and 1.9% in 2022. These projections factor in Moody's expectation of higher-for-longer interest rates, with the average annual 10-year Treasury yield peaking at around 4.5% in 2024 and ultimately settling at around 4% over the medium term.

The debt affordability forecasts also take into account Moody's expectations that, absent significant policy changes, the federal government will continue to run wide fiscal deficits of around 6% of GDP near term and to around 8% by 2033, the widening being driven by higher interest payments and aging-related entitlement spending. By comparison, deficits averaged around 3.5% of GDP from 2015 to 2019. Such deficits will raise the US federal government's debt burden to around 120% of GDP by 2033 from 96% in 2022. In turn, a higher debt burden will inflate the interest bill.

The US is the world's largest economy and the center of global trade and finance, supported by flexible markets and open trade and financial regimes. The US is the only sovereign to which Moody's assigns an economic strength score of "aaa," the highest score possible, reflecting the sheer scale of the economy (nominal GDP was nearly $26 trillion in 2022), consistent resilience to shocks, and the unique role that the economy plays globally. The resilience of the economy has again been demonstrated in recent years.

Comparatively rapid productivity growth and a high degree of technological innovation reinforce the US economy's competitiveness and contribute to GDP growth rates that outpace those of many high-income countries, which Moody's expects to continue. Moody's also expects the US economy and the sovereign's credit profile to remain resilient to shocks, including from current challenges related to inflation and tightening financial conditions. US GDP growth could exceed Moody's baseline expectations if the economy can maximize productivity benefits from new and emerging technologies. In turn, positive growth surprises would support government revenue, even if fiscal policy remained unchanged, thereby helping to slow the deterioration in debt affordability.

Moody's expects US institutions, including the Federal Reserve, to effectively manage these challenges. More generally, the strength of US institutions and governance provides strong support to the economy and its resilience to shocks, underpinned by independent institutions, high regard for the rule of law, constitutional separation of powers, and high levels of transparency.

In particular, US monetary and macroeconomic policy has demonstrated a long history of effectiveness. While the adjustment of the US economy and financial sector to higher-for-longer interest rates is underway, policymakers have facilitated the transition through transparent and effective implementation of policies. Moody expects the Federal Reserve to ultimately achieve its dual mandate, although through a process that will result in a more pronounced slowdown in demand and may involve some pockets of banking sector stress in the near term.

As mentioned above, other aspects of policymaking are less robust than in many Aaa-rated peers, particularly about fiscal policy. This is reflected in Moody's weaker assessments of the quality of legislative and executive institutions, and fiscal policy effectiveness.

Due to the global dominance of the dollar as a reserve currency, Moody's considers the US to have a significantly higher capacity to carry a larger debt burden than other sovereigns globally. While by some metrics, the role of the US dollar in global trade and financial transactions has diminished, its dominance remains extraordinary. Today, the US dollar is the world's preeminent reserve currency, with around 58% of global foreign exchange reserves held in dollar-denominated assets as of the end of 2022.

Meanwhile, the US Treasury bond market is by far the deepest and most liquid government securities market in the world. A significant proportion of Treasury securities are held by non-residents, reflecting their preeminent safe-haven status, which has been confirmed through recent global shocks. The global benchmark roles of the US dollar and Treasury bond market insulate the US sovereign from many downside risks. In particular, they remove all but the most extreme liquidity and balance of payments risks, despite a rising debt burden, by removing the risk of spiraling debt costs.

For a reserve currency country like the US, debt affordability - more than the debt burden - determines fiscal strength. As a result, in the absence of measures that limit the size of fiscal deficits, fiscal strength will increasingly weigh on the US credit profile.

FISCAL RISKS ARE EXACERBATED BY ENTRENCHED POLITICAL POLARIZATION UNDERSCORING RISING POLITICAL RISK

At a time of weakening fiscal strength, there is an increased risk that political divisions could further constrain the effectiveness of policymaking by preventing policy action that would slow the deterioration in debt affordability. These risks underscore rising political risk to the US fiscal position and overall sovereign credit profile.

Recently, multiple events have illustrated the depth of political divisions in the US: renewed debt limit brinkmanship, the first ouster of a House Speaker in US history, the prolonged inability of Congress to select a new House Speaker, and increased threats of another partial government shutdown due to Congress's inability to agree on budgetary appropriations.

In Moody's view, such political polarization is likely to continue. As a result, building political consensus around a comprehensive, credible multi-year plan to arrest and reverse widening fiscal deficits through measures that would increase government revenue or reform entitlement spending appears extremely difficult.

While the US' Aaa rating takes into account relative weaknesses with regard to the quality of the country's legislative and executive institutions and fiscal policy effectiveness compared to other Aaa-rated sovereigns, there is a risk that these weaknesses take greater credit relevance because the deteriorating debt affordability trend would call for a more significant and effective fiscal policy response.

In particular, the US' lack of an institutional focus on medium-term fiscal planning, either through legislated fiscal rules aimed at improving the fiscal balance or general bipartisan consensus on the need for fiscal consolidation, is fundamentally different from what is seen in most other Aaa-rated peers such as in Government of Germany (Aaa stable) and Government of Canada (Aaa stable).

Meanwhile, the more short-term focus of US fiscal policymaking, along with limited fiscal flexibility - because a very large portion of nondiscretionary budgetary spending is on mandatory entitlement programs and debt service (around 75% of total outlays), exacerbates already fractious bipartisan politics around a relatively disjointed and disruptive budget process. As annual debt service costs continue to rise, fiscal flexibility will diminish even further.

RATIONALE FOR AFFIRMATION OF Aaa RATINGS

The affirmation of the Aaa ratings reflects Moody's view that, despite rising fiscal pressures and political risk, the US' formidable credit strengths continue to preserve the sovereign's rating, in particular exceptional economic strength, high institutional and governance strength, and the unique and central roles of the US dollar and Treasury bond market in the global financial system.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

The US ESG Credit Impact Score is CIS-2, indicating that ESG considerations are not material to the rating. For the US, this reflects moderately negative exposure to social risks and a strong governance profile that supports the sovereign's resilience and capacity to respond to shocks.

At the federal level, the US exposure to environmental risks is neutral-to-low (E-2) reflecting the country's relatively limited exposure across all categories, including physical climate risk, carbon transition, natural resources management, waste and pollution.

The US' exposure to social risks is moderately negative (S-3), driven mainly by demographics and socioeconomic inequalities. Over the longer term, an aging population and rising healthcare costs will increase age-related entitlement spending and contribute to increased pressures on the sovereign's weakening fiscal position. If left unaddressed, relatively high income inequality, along with wealth and opportunity disparities could exacerbate political divisions and further increase political risks and social unrest, contributing to a faster decline in US fiscal strength.

The US' very strong institutions and governance profile (G-1) supports its overall sovereign credit rating and is reflected in both a strong institutional framework and demonstrated policy effectiveness, especially with regard to monetary and macroeconomic policy.

SUMMARY OF MINUTES FROM RATING COMMITTEE

GDP per capita (PPP basis, US$):  76,343 (2022); (also known as Per Capita Income)

Real GDP growth (% change):  1.9% (2022); (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec):  6.5% (2022)

Gen. Gov. Financial Balance/GDP:  -4.4% (2022); (also known as Fiscal Balance)

Current Account Balance/GDP:  -3.8% (2022)  (also known as External Balance)

External debt/GDP:  90.3% (2022)

Economic resiliency:  aa1

Default history:  No default events (on bonds or loans) have been recorded since 1983.

On 07 November 2023, a rating committee was called to discuss the rating of the United States of America, Government of. The main points raised during the discussion were: The issuer's economic fundamentals, including its economic strength, have not materially changed. The issuer's institutions and governance strength have not materially changed. The issuer's fiscal or financial strength, including its debt profile, has materially changed. The issuer's susceptibility to political event risk has materially changed.

FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS

The US rating is Aaa, which is already at the top of Moody's rating scale. An upgrade to a higher rating is therefore not possible. Moody's could change the outlook back to stable if it expected the government to adopt fiscal policy measures that helped to slow the expected deterioration in debt affordability and decline in fiscal strength, for example by contributing to a structural narrowing of primary fiscal deficits through increased government revenues or reduced spending. The outlook may also change to stable if it becomes increasingly likely that the US growth potential is durably higher than Moody's current estimates, which would boost government revenue and slow the deterioration in debt affordability.

The US rating would face downward pressure if Moody's were to conclude that policymakers were unlikely to respond to the country's growing fiscal challenges over the medium term, through measures to increase government revenue or structurally reduce spending to slow the deterioration in debt affordability. Under this scenario, a downgrade would reflect higher confidence that the deterioration in debt affordability and fiscal strength was likely to undermine the US economic strength and/or the role of the US dollar and Treasury bond market.

A weakening of institutions and governance strength, such as through deterioration in monetary and macroeconomic policy effectiveness or the quality of legislative and judicial institutions, could also strain the rating. Such an outcome would weigh on the sovereign credit profile, particularly if it were to reduce confidence that the US dollar and Treasury bond market will retain their unique and central roles in the global financial system, which currently bring considerable support to the rating.

Overall, Moody’s downgraded the US outlook to negative primarily for expected higher borrowing cost of public/government debt amid higher bond yields due to the Fed’s higher for longer policy to bring core inflation durably under the +2.0% target; the Fed is now also on QT mode rather than QE, which is reducing demand of US bonds/debts and resulting in higher bond yields. So far, the U.S. Treasury/Fed can manage the debt interest/tax revenue ratio below 10%; the FY22 ratio was around 9.72% almost at par with pre-COVOD levels, but still almost double than average Europe/EU and Chinese levels.

The U.S. CBO estimated debt interest/tax revenue of around 13.77%, 15.37%, and 15.54% respectively for FY:23-25, almost at par with Japan. Moreover, Moody’s now estimating the leverage ratio (debt interest/tax revenue) at around 26% by FY33 assuming an average 4% bond yield for a US10Y bond if the U.S. is not able to increase its revenue or social security grants (expenses) significantly. There is a need for a bipartisan political plan for the medium/long term to do this.

But in the U.S., there is increasing political and policy paralysis as no one party can form a credible/stable majority government at the White House/House/Senate. This is partly because of the U.S. political system of voting every two years (main Presidential and mid-term elections). Even if one party got a majority (trifecta) by winning the House, Senate and White House, after 2-years of incumbency wave, the majority party in the Presidential election is set to lose majority (trifecta) in the mid-term election and then have to run a minority government, affecting policy planning/implementations. This was the case for Trump/Republicans in 2016 and now for Biden/Democrats in 2020 also; Biden’s trifecta was lost in the Nov’22 mid-term election and now he is running a minority government, highly dependent on opposition party Republican’s whims & fancies (policies).

Democrats generally prefer fiscal stimulus and tax hikes, especially on the rich, while Republicans generally prefer tax cuts and lower fiscal stimulus; but both parties generally want lower/near zero Fed policy rate and lowest borrowing costs to fund the never-ending (open-ended) credit card expenses (public debt) at affordable cost. Democrats are generally more war savvy (far away from US soil) than Republicans; the U.S. is always the greatest beneficiary of a major war (like Russia-Ukraine, Gaza war) as it’s the biggest producer of military equipment and oil; such war acts as a fiscal stimulus for the U.S. economy (in the same of national security). Also, the global reserve currency status of USD helps a lot as USD is always in demand, despite the 24/7 busy printing press at Fed/TSY.

In this way, increasing U.S. government borrowing will eventually ensure higher inflation and higher borrowing costs for longer, although the U.S. will never default. But all these issues are already known by the market and S&P Global, Fitch has already downgraded the U.S. outlook some months ago. The market was also expecting such a downgrade by Democrat-savvy Moody’s by Dec’23 and thus the overall impact was quite limited such a downgrade will also keep the Fed on rate cuts from H2CY24 (in line with market expectations). Thus Wall Street recovered and Gold slipped to some extent.

In the early Monday Asian Session, Gold flash crashed from around 1943 to almost 1922 on the progress of the Gaza war's longer pause/ceasefire. As per some Israeli media reports late Sunday, there was some progress toward a deal to free captives held by Hamas in Gaza. Israel’s PM Benjamin Netanyahu said he would not discuss details of any possible deal, which may involve 50 to 100 women, children and elderly people being released in stages during a three-to-five-day pause in fighting. According to the reports, Israel would release women and minor Palestinian prisoners and consider letting fuel into Gaza, while reserving the right to resume fighting. Hamas Armed Wing told mediators that the group is ready to release up to 70 children and women held in Gaza in a 5-day truce.

But on late Monday, a Hamas spokesman accused Israel of changing captive negotiation terms at the last minute. He said the most recent arrangement would have seen Israel release 200 children and 75 women from Israeli jails in exchange for the release of 50 captives over five days. He said Hamas’s condition was also that Israel allows unfettered aid access to Gaza via the Rafah crossing with Egypt, including the entry of fuel into the besieged Palestinian enclave:

“When all those arrangements were done, the Israelis postponed that … It shows that they are not willing to go forward. They did not reject [the deal]. There was an agreement about this and in the end, they added more conditions. Israelis were seeking more names of the captives, which Hamas has been unable to collect because many were taken by different factions in Gaza. If the Israeli side came back to the mediators today and said we are ready to implement [the agreement], things will go forward. I believe that the mediators are doing their best to bring them [the Israelis] back.”

Overall, Israel/IDF is now in the process of securing/controlling Gaza City completely including hospitals and other suspected hideouts of Hamas, including the suspected Hamas HQ beneath the AI QUAD hospital and may officially announce the full control of Gaza City by the next few days and subsequent Ceasefire for at least 3/5-days for release of adequate hostages.

The U.S. CIA Director is personally involved in the overall negotiation process with Hamas through Qatar mediation and the backdoor negotiation is very active as both Israel and the U.S. are now under huge global as well as local pressure for an immediate ceasefire of the Gaza war and focuses more on targeted operations than the ongoing mass carnage. There was also an unverified report about the Hamas rocket attack on Tel Aviv, while Israel claimed almost full control of Gaza City along with hospitals, where hostages could be held up including 10 suspected US nationals.

On Monday, Israel PM Netanyahu vowed to eradicate Hamas in a boost-up speech for the IDF: "This is neither an operation nor a 'round' but a war to the end. It is important to me that you know this. This is not lip service but from the heart and mind. If we do not finish them, it will come back”.

Market wrap:

On Monday, Wall Street futures closed almost flat amid lingering suspense about the Gaza war ceasefire and the limited impact of Moody’s US outlook downgrade. The market was also cautious ahead of the U.S. core CPI report Tuesday. On Monday, Wall Street was boosted by energy (higher oil amid upbeat OPEC forecast), healthcare, consumer staples, consumer discretionary, and industrials while dragged by utilities, real estate, techs, communication services, banks & financials and materials. Dow Jones (DJ-30) was boosted by Boeing (hopes of China ban lifting), Caterpillar, Salesforce, Wall Mart, Goldman Sachs and United Health, while dragged by Home Depot, Microsoft, Nike, Apple, IBM, JPM, Intel and Amgen. Nvidia got some boost on the H100 AI Chip update, while Tesla jumped on import tax concession by India, a possible huge market after China (outside the U.S.).

Technical trading levels: DJ-30, NQ-100 Future

Whatever the narrative, technically Dow Future (34385), now has to sustain over 34550 for any further rally to 34650-34855 and further to 35375-35875 in the coming days (if there is a Gaza ceasefire/Israel ends its intensifying surgical/military operation).; on the other side, sustaining below 34450/400-34300/34250, Dow Future may again fall to 33950/33650-33450/33150 and 32950/32650-32300/32200 and 32000/31750-31595/31190 and even 29400-28475 levels (in case of a wider major regional military conflict).

Similarly, NQ-100 Future (15575), now has to sustain over 15850 for any further rally to 5975/16075 in the coming days; otherwise sustaining below 15750/15600-15500/15450, may again fall to 15300 and again 15100/15000 and 14800/14600-14450/14300-14200/14100 and 14000/13800-13650/13500-13395/12990 and 12790/12400-12180/11650 and even 11000-10675 in the coming days. (under the worst scenario of Gaza regional war).