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  • Gold, S&P, Central Bank, market reactions and the economy
    The USA is no longer AAA following the decision by S&P to downgrade the credit to AA+ and keep it on negative watch. What will be the short and long term effects on the market and the economy?
    I'll start with a few comments on the short term effects. I don't expect US treasuries to react. In fact, they may rally if equities get hit (flight to quality believe it or not). The implications for equities and the greenback are negative. On the economic front the primary damage will likely be to consumer confidence. The possibility of a downgrade has been in the market for some time so one can argue that the market has been prepared. Still, this is negative. The main beneficiaries of this should be safe haven currencies (like the CHF) and gold.
    Will be interesting to follow the circus in Washington. The blame game will be huge with each party blaming the other and never admitting its own (multiple) mistakes. This is going to be lively. Also, they are likely to shoot the messenger (S&P in this case). We've already seen the ''mathematical error'' argument. I can say that there is no mathematical error at all and this so called ''error'' relates to assumptions used in the economic model. Given the latest numbers from the economy, I believe that the economic model currently used for the rating is too optimistic and we are likely to have higher deficits (and more debt) than projected, resulting in perhaps further downgrades.
    Longer term we are likely to see a negative effect on US Treasuries as well.  The problem is that the Treasury will need to issue additional net debt to fund the large fiscal deficits. It is hard to argue that the downgrade will help attract new investors. I think that the big investors in US Treasuries will not sell now (the really big ones like China simply cannot sell) but some of them are likely to be smaller buyers going forward. China has already said that they would look to diversify over time and the downgrade is likely to make this decision firmer. The result would be higher yields than we would otherwise have.
    All this is likely to force the FED to start buying government bonds again at some point - monetizing the debt through money printing aka QE. This is already likely given the weaker economy but lower interest in the government bond market and weaker auctions may force their hand. I think that this is quite likely.
    It is interesting to compare this to what is going on in Japan and Europe. The BOJ just announced a fresh QE program and the ECB is going to start buying Italian and Spanish government bonds. The ECB will also have to fund the European banking system. Of course, they take collateral against their bank loans but the value of the collateral is very questionable and this is just another type of QE as many of these bank loans will never be repaid by insolvent European banks. We are seeing a GQE1 (Global Quantitative Easing) by the main developed markets Central Banks. I doubt that the FED is going to stay on the sidelines for long, especially if equities are weak and commodity prices stable/weak. 
    I predict gold going to $1800 or higher by year end on the back of this.



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Aug 06 7:51 AM | Link | Comment!
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