Sunday, January 30, 2011

S&P Downgrades Japan's Sovereign Debt

By Dan Norcini

The news that the rating agency S&P had downgraded Japan's sovereign debt from 'AA' to 'AA-'. This is no small development. The reality is that Japan's finances are in even worse shape than those of the US when its overall indebtedness is compared as a percentage of GDP. Japan is approaching a debt to GDP ratio of nearly 200%! Yes, you read that correctly. The only nation in the entire world that is higher is Zimbabwe. In effect, it would take the sum total of all economic activity generated in Japan over a two year period to eliminate the nation's debt. Think about that!

What this means is that the rating agencies, who are watching these sovereign debt woes which have struck various countries in the EU, are concerned about the same problem beginning to surface in other quarters around the globe. Quite simply they are looking at the huge deficits being run by many nations in the West (and Japan). In other words - TOO MUCH DEBT!

That led to selling in the long end of the US yield curve this morning as bond traders are starting to be more than a bit fearful that the same thing is going to happen to the US's 'AAA' rating at some point in the future if the US does not get its financial house in order. They are watching massive amounts of QE2 and another ballooning of the federal budget deficit and are selling even as the Fed attempts to jam the market higher with its purchases. AT this point, the only thing holding the long end of the curve is the Fed. How long can that last especially without affecting the Dollar?

More and more we see the integrity of sovereign debt being brought into doubt which leads to the question among many investors; "what is a safe haven that is actually safe?" Who wants to take the chance of holding a nation's bonds if overnight they face the real risk of being downgraded?

The real world impact of this is that nations whose debt gets downgraded will have to offer potential investors a higher rate of return to compensate them for the increased risk of holding their debt. For nations already hopelessly in debt, that means borrowing costs begin to rise forcing them to borrow even more money just to keep their heads above water. The whole thing becomes a vicious cycle with rising interest rates compounding the problem.

The US has been able to sneak by and thus far avoid a rating agency's downgrade partly because its borrowing costs are so low. Should these agencies begin to train their sights on the US and give closer scrutiny to its miserable financial condition, there is a chance that a downgrade could follow. Such a development, were it to indeed occur, would force the US to offer higher rates of return on its debt. That of course would raise its borrowing costs at a time when it can least afford it not to mention short circuiting the QE policy which is deliberately designed to lower borrowing costs.

This is why the take down in gold, after yesterday's nice performance, is so remarkable for its perverseness and why long term oriented holders of the metal should not be the least bit concerned as to the antics taking place in the paper market. Sovereign debt woes are not behind us - the problem lies squarely ahead of us and no amount of wishful thinking is going to change that hard reality.

This being said, one of the things we now want to monitor will be the performance of gold when priced in terms of the Yen.

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