Moody's Downgrades the UK, GBP/USD Breaks Support, GBP/AUD Testing 2012 Low (#CurrencyWars)

In my previous post on the UK's inflation rate, 10-year Gilt yield, GBP/USD and FTSE 250, I forgot to mention there was risk of a credit rating downgrade. Moody's and other credit rating agencies have been warning about a downgrade for months (Moody's (2), S&P, Fitch (2)). The combination of the UK's high debt/GDP ratio, deficit, slow economic growth and fiscal consolidation brought on the downgrade. Like we've seen in Eurozone, it's hard for a country to attack its debt and deficit problem in a major way if austerity measures slow economic growth during a deleveraging cycle. The UK has a total credit market debt-to-GDP percentage above 900%! (look at the G10 debt distribution chart at Zero Hedge.) WOW. And check out this chart of the UK's real home price index vs. its inverse dependency ratio going forward (demographics) (previous post via Business Insider).

For more info on what's going on read hedge fund manager Ray Dalio's research reports on deleveragings and how the economic machine works. He runs Bridgewater Associates, the largest hedge fund in the world with $130 billion under management.

Of course, to offset this negative effect, the Bank of England has been printing money to buy government bonds to push interest rates lower, devalue its currency (boost exports), boost asset prices, and stimulate its economy (like the Federal Reserve and Bank of Japan have been doing, and soon every central bank). That's why there is global a currency war right now (see interviews with Jim Rickards). Check out the charts of GBP/USD, GBP/AUD and GBP/JPY below.

Here is selected text from Moody's release on the downgrade (emphasis mine):

Moody's downgrades UK's government bond rating to Aa1 from Aaa; outlook is now stable

Global Credit Research - 22 Feb 2013

London, 22 February 2013 -- Moody's Investors Service has today downgraded the domestic- and foreign-currency government bond ratings of the United Kingdom by one notch to Aa1 from Aaa. The outlook on the ratings is now stable.

The key interrelated drivers of today's action are:

1. The continuing weakness in the UK's medium-term growth outlook, with a period of sluggish growth which Moody's now expects will extend into the second half of the decade;

2. The challenges that subdued medium-term growth prospects pose to the government's fiscal consolidation programme, which will now extend well into the next parliament;

3. And, as a consequence of the UK's high and rising debt burden, a deterioration in the shock-absorption capacity of the government's balance sheet, which is unlikely to reverse before 2016.

At the same time, Moody's explains that the UK's creditworthiness remains extremely high, rated at Aa1, because of the country's significant credit strengths. These include (i) a highly competitive, well-diversified economy; (ii) a strong track record of fiscal consolidation and a robust institutional structure; and (iii) a favourable debt structure, with supportive domestic demand for government debt, the longest average maturity structure (15 years) among all highly rated sovereigns globally and the resulting reduced interest rate risk on UK debt.

The stable outlook on the UK's Aa1 sovereign rating reflects Moody's expectation that a combination of political will and medium-term fundamental underlying economic strengths will, in time, allow the government to implement its fiscal consolidation plan and reverse the UK's debt trajectory. Moreover, although the UK's economy has considerable risk exposure through trade and financial linkages to a potential escalation in the euro area sovereign debt crisis, its contagion risk is mitigated by the flexibility afforded by the UK's independent monetary policy framework and sterling's global reserve currency status.

In a related rating action, Moody's has today also downgraded the ratings of the Bank of England to Aa1 from Aaa. The issuer's P-1 rating is unaffected by this rating action. The rating outlook for this entity is now also stable.

RATINGS RATIONALE

The main driver underpinning Moody's decision to downgrade the UK's government bond rating to Aa1 is the increasing clarity that, despite considerable structural economic strengths, the UK's economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the UK economy from the ongoing domestic public- and private-sector deleveraging process. Moody's says that the country's current economic recovery has already proven to be significantly slower -- and believes that it will likely remain so -- compared with the recovery observed after previous recessions, such as those of the 1970s, early 1980s and early 1990s. Moreover, while the government's recent Funding for Lending Scheme has the potential to support a surge in growth, Moody's believes the risks to the growth outlook remain skewed to the downside.

The sluggish growth environment in turn poses an increasing challenge to the government's fiscal consolidation efforts, which represents the second driver informing Moody's one-notch downgrade of the UK's sovereign rating. When Moody's changed the outlook on the UK's rating to negative in February 2012, the rating agency cited concerns over the increased uncertainty regarding the pace of fiscal consolidation due to materially weaker growth prospects, which contributed to higher than previously expected projections for the deficit, and consequently also an expected rise in the debt burden. Moody's now expects that the UK's gross general government debt level will peak at just over 96% of GDP in 2016. The rating agency says that it would have expected it to peak at a higher level if the government had not reduced its debt stock by transferring funds from the Asset Purchase Facility -- which will equal to roughly 3.7% of GDP in total -- as announced in November 2012.

More specifically, projected tax revenue increases have been difficult to achieve in the UK due to the challenging economic environment. As a result, the weaker economic outturn has substantially slowed the anticipated pace of deficit and debt-to-GDP reduction, and is likely to continue to do so over the medium term. After it was elected in 2010, the government outlined a fiscal consolidation programme that would run through this parliament's five-year term and place the net public-sector debt-to-GDP ratio on a declining trajectory by the 2015-16 financial year. (Although it was not one of the government's targets, Moody's had expected the UK's gross general government debt -- a key debt metric in the rating agency's analysis -- to start declining in the 2014-15 financial year.) Now, however, the government has announced that fiscal consolidation will extend into the next parliament, which necessarily makes their implementation less certain.

Taken together, the slower-than-expected recovery, the higher debt load and the policy uncertainties combine to form the third driver of today's rating action -- namely, the erosion of the shock-absorption capacity of the UK's balance sheet. Moody's believes that the mounting debt levels in a low-growth environment have impaired the sovereign's ability to contain and quickly reverse the impact of adverse economic or financial shocks. For example, given the pace of deficit and debt reduction that Moody's has observed since 2010, there is a risk that the UK government may not be able to reverse the debt trajectory before the next economic shock or cyclical downturn in the economy.

In summary, although the UK's debt-servicing capacity remains very strong and very capable of withstanding further adverse economic and financial shocks, it does not at present possess the extraordinary resilience common to other Aaa-rated issuers.

RATIONALE FOR STABLE OUTLOOK

The stable outlook on the UK's Aa1 sovereign rating partly reflects the strengths that underpin the Aa1 rating itself -- the underlying economic strength and fiscal policy commitment which Moody's expects will ultimately allow the UK government to reverse the debt trajectory. The stable outlook is also an indication of the fact that Moody's does not expect further additional material deterioration in the UK's economic prospects or additional material difficulties in implementing fiscal consolidation. It also reflects the greater capacity of the UK government compared with its euro area peers to absorb shocks resulting from any further escalation in the euro area sovereign debt crisis, given (1) the absence of the contingent liabilities from mutual support mechanisms that euro area members face; (2) the UK's more limited trade dependence on the euro area; and (3) the policy flexibility that the UK derives from having its own national currency, which is a global reserve currency. Lastly, the UK also benefits from a considerably longer-than-average debt-maturity schedule, making the country's debt-servicing costs less vulnerable to swings in interest rates.

WHAT COULD MOVE THE RATING UP/DOWN

As reflected by the stable rating outlook, Moody's does not anticipate any movement in the rating over the next 12-18 months. However, downward pressure on the rating could arise if government policies were unable to stabilise and begin to ease the UK's debt burden during the multi-year fiscal consolidation programme. Moody's could also downgrade the UK's government debt rating further in the event of an additional material deterioration in the country's economic prospects or reduced political commitment to fiscal consolidation.

Conversely, Moody's would consider changing the outlook on the UK's rating to positive, and ultimately upgrading the rating back to Aaa, in the event of much more rapid economic growth and debt-to-GDP reduction than Moody's is currently anticipating.

So, GBP/USD decided to use the downgrade as a catalyst to crash through 1.523 support again after piercing through it a few days after my post (and rallying back to 1.53). It looks like there was a confirmed breakdown for lower levels, but it all depends on what the Bank of England does relative to the Federal Reserve as new economic data comes in (printing press wars). Also watch GBP/AUD's previous low. If it trades around 1.4555 it could attempt to break down and hit a new low.

source: freestockcharts.com

source: freestockcharts.com

source: freestockcharts.com

Check out GBP/AUD's monthly chart. It is testing a MAJOR multi-year low that must hold.



Daily & weekly GBP/AUD charts.




Here's an interesting currency war to watch, GBP/JPY.


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