Downgrade sparks gold, bond rally

The U.S. government’s credit downgrade has added more fuel to the fire which swept the equity markets last week, burning a massive hole in portfolios around the world. Money managers say the downgrade might not have been expected on Friday night, but it certainly didn’t come as a surprise.

“This debt didn’t just suddenly appear overnight,” says Charles Oliver, senior portfolio manager, Sprott Gold & Precious Minerals Fund. “The issues of entitlement spending didn’t appear overnight—these are things that have been out there for a long time.”

He says the primary catalyst for the downgrade seems to have been the U.S. government’s inability to work in the best interests of its people.

The result has been a stampede out of the equity market, into gold—up 3% on the day—and perhaps surprisingly U.S. bonds—up 2%.

As a precious metals fund manager, Oliver says the debt issue has benefited his fund, but it is hard to find much joy in watching the world’s governments debase their currencies as a means of solving their debt problems.

“It’s never fun watching these things go down,” he says. “Just last week we heard from the Swiss and the Japanese that both of their currencies were too strong, and that they were both actively going to try to weaken their currencies. It looks like all of the major countries around the world are in a race to debase their currencies the fastest.”

Even Canada is debasing its currency, he says, although this is only apparent relative to gold, rather than versus other currencies.

“The Chinese credit rating agencies have already downgraded the U.S.,” he says. “Often once somebody has stepped up and said ‘there is an issue here, we have concerns’, others come out of the woodwork. It’s quite possible that you could see downgrades by [Moody’s or Fitch] in the future.”

In a conference call on Friday, S&P mentioned that five countries—Canada, Australia, Finland, Sweden and Denmark—had recovered their AAA ratings after a downgrade. The range of time for these recoveries was between nine and 18 years.

“It certainly makes one ponder how long it will take the U.S. to hopefully regain its AAA credit rating,” Oliver says. “The big issue is too much debt and too many entitlement benefits. Its 2011: the first babyboomers are turning 66 and you have these huge increases in healthcare coming down the pipeline.”

Healthcare costs are expected to rise from $800 billion in 2011 to $1.6 trillion in 2019, according to the Congressional Budget Office. Add to that, the costs of social security and the decline in income tax revenues as the boomers retire.

Despite the downgrade, U.S. bonds are rallying today, which Oliver finds perplexing.

“I was just shaking my head at my desk,” he says. “How many times have you ever seen a country get a sovereign downgrade, only to have its bonds rally? They’re up about 2%, while gold is up 3%. I’ve never seen that before.”

Justin Charbonneau, vice-president, portfolio manager, Matco Financial in Calgary, says there is an easy explanation for the rally in U.S. debt.

“There’s nowhere else to go,” he says “Especially with Europe in such tough shape, the U.S. is the deepest market in terms of currency, bonds and liquidity. The downgrade is a headline risk, for sure…but it’s not the end of the world.”

He points out that while Canadian government debt remains AAA-rated, the market is simply too small for foreign investors to bother with.

“The risk has gone up, with the gridlock and lack of leadership in the U.S.,” he said. “When you look at equity markets, it’s clearly pricing in the risk of a double dip recession.”

But he points out that credit markets remain liquid—a key difference from the 2008 crisis. Even within Europe, banks continue to lend to one another, although tensions are rising.

“The timing of the downgrade was a bit of a surprise,” says Charbonneau. “Moody’s and Fitch had come out the day after the U.S. raised the debt ceiling and reaffirmed triple-A. The S&P [downgrade] came late in the game.”

He suspects that S&P’s intentions were leaked, sparking the sell-off on Thursday. The downgrade itself may have been an effort by S&P to demonstrate it is not biased in favour of U.S. debt, after it—along with Moody’s and Fitch—had downgraded several European issuers.