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Forex Blog - Sovereign Credit Risk Next Big FX Trade?

Sovereign Credit Risk Next Big FX Trade?

 

I can’t help but be a little cynical when I hear or read how sovereign credit risk will be the trade of 2010.  For starters it demands a suspension of disbelief…2010 in all markets will be driven by what Moody’s, S&P and Fitch decide for sovereign debt ratings?  If the public knew this was the case they might bring pikes and torches in their march on Wall Street over compensation without contrition.  What rational body would rely on a rating agency to discern sound credit ratings for the movement vast sums of money around (surely compliance on both the buy and sell side are revisiting the use of rating agency ratings for the allocation of risk capital) after the same rating agencies got MBS market so unforgivably wrong?  Okay rating a sovereign debt issuer is not the same level of expertise demanded in rating some securitized bundle of subprime mortgages.  But is still stretches one’s imagination to think this band of raters can get even simple credit risk right and especially so if one looks at the Asia crisis, Russian debt crisis and Brazil debt crisis…rating agencies were quick to move after the crises fully bloomed.  And many sovereign debt investors are already noting how upside down existing sovereign ratings are – US and UK are AAA and Brazil and India are barely investment grade (2009 and 2007 respectively) when US and UK fiscal balances are alarmingly unsustainable while Brazil and India fiscal balances are quite manageable. This is not a new idea…plenty are short weak AAA’s and long strong BBB-‘s…credit rating arbitrage 

 

I also think the sovereign risk is self cancelling for a number of key countries…US and EZ for instance.  Greece, Spain, Portugal, Ireland and even Italy look like weak credits.  So sell the EUR in 2010.  But US states are weak credits…California, New Jersey and soon New York are all looking like fiscal train wrecks.  Sure the US federal government is likely to stand behind state debt, though it is not obligated (hard to believe too big to fail applies to large banks but not large states).  But it is equally inconceivable that EZ would let Greece or Spain default.  Frankly I don’t see a real trade here…the role of Greece in the slide in EURUSD since payrolls is incidental I believe.  What is more significant is the amassing of US economic data pointing at a relatively robust Q4 and perhaps an earlier withdrawal of QE and conventional stimulus than is widely perceived?    

 

Yes sovereign credit is important in 2010 as debt issuance globally soars to fund government stimulus programs and will surely play a part in government bond yields – prop them up as is already underway.  But, I simply don’t see much of a case for pricing key FX pairs on a best-of-the-weakest basis.  However, the sovereign story should play (is playing) a much larger role in asset class allocation (stocks, especially dividend paying ones, over bonds).   And let’s hope that financial markets, for the sake of more general credibility, do not “default” to the credit rating agencies rating game for the sovereign trades of 2010.

 

David Gilmore

 

 

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