For the first time since it began rating the creditworthiness of railroad bonds in 1860, Standard and Poor’s has issued a “negative” outlook on the U.S. government, citing increased concerns about Washington’s ability to manage the federal budget.
The move stopped short of an outright cut in the country's top AAA credit rating. But Monday’s outlook change means the agency believes there is a one in three chance that such a cut will happen in the next two years, S&P said.
“This is a very big deal,” said Dan Greenhaus, chief strategist at Miller Tabak. “This announcement is very much a shot across the bow that you can't simply cut taxes and increase spending in perpetuity and expect there to be no ramifications in the bond or currency markets."
Market reaction to Monday’s announcement was swift. The dollar dropped sharply against both the Euro and the yen, as investors sold U.S. debt. Gold prices surged and stock prices fell.
Cutting the U.S. debt rating would have dire consequences for the Treasury. To attract investors, it would have to raise interest rates substantially when it sells new debt or rolls over shorter-term portions of the more than $14 trillion in debt outstanding. Many investment funds, barred from holding anything but AAA-rated investments, would have to dump their holdings, forcing rates higher still.
Higher rates could also put a choke hold on the recovery as they seep through the economy and make it more expensive to borrow to buy a car, a home or start a business.
The flow of capital out of Treasury securities would put heavy pressure on the dollar, and that would push oil prices higher.
"The U.S. debt situation got a reality check this morning from the move by S&P," said John Kilduff, partner at Again Capital in New York. "Only precious metals will be seen as attractive in the aftermath of the outlook downgrade."
The nation's outstanding public debt has swelled to more than 60 percent of gross domestic product in the aftermath of the 2007-2009 economic downturn and financial crisis. And the debt is rising, with an annual budget deficit currently at nearly 10 percent of GDP.
S&P noted that between 2003 and 2008, the deficit ranged between 2 percent and 5 percent of GDP before ballooning to 11 percent in 2009 - higher than other countries with a AAA rating.
The agency gives its top investment rating to just 19 of the 127 countries it analyzes. But it says Britain, France and Germany have moved much more quickly to contain deficits after the 2008 financial crisis and 2007-2009 recession -- which cut tax revenues and forced governments to spend more on unemployment benefits, aid to the poor and bailouts of the banking system.
The White House sought to downplay the impact of S&P's move, saying progess was being made toward a budget resolution.
"Any call for a bipartisan agreement on deficit reduction on fiscal reform is a welcome one, and in that context, I think that (the S&P move) adds to what we believe is some momentum towards that end," said White House spokesmanJay Carney.
Another administration official reiterated the U.S. commitment to act on the deficit and said S&P underestimated that resolve.
"We believe S&P's negative outlook underestimates the ability of America's leaders to come together to address the difficult fiscal challenges facing the nation," said Mary Miller, assistant treasury secretary for financial markets.
Though the timing of S&P’s announcement was a surprise, many investors said the move was not entirely unexpected.
"We are talking about issues that have been around and building for the past 10, 15, 20, 30 years,” said money manager Christopher Hobart, at the Hobart Financial Group. “Here we are. It has come due.”
In explaining its negative outlook, S&P noted that a return to a “stable” outlook would require meaningful progress to balancing the budget by 2013. That would mean Congress and the White House would have to agree to a plan to cut spending and raise revenues before the 2012 elections, which have already begun to color the budget debate.
Some analysts suggested that, by effectively setting a deadline for action on the federal budget impasse, S&P's downgrade may help break the political stalemate in Washington.
"If the rising risk of a downgrade gives the fiscal austerity debate a greater sense of urgency, then it might even turn out to be a positive development," said Paul Ashford, chief US economist at Capital Economics.
The Obama administration last week announced plans to trim $4 trillion from the budget deficit over the next 12 years, mostly through spending cuts and tax hikes on the rich. But a more contentious battle over a long-term plan to tame the $1.5 trillion budget deficit has focused attention on the upcoming vote to raise the limit on the government’s borrowing authority. The Treasury has said it expects to hit the limit of that authority in mid May.
On Sunday, Treasury Secretary Timothy Geithner said congressional Republicans have assured the Obama adminstration that they would not hold the economy hostage over raising the debt ceiling.
"They recognize it and they told the president that on Wednesday in the White House,” Geithner told ABC. "And I sat there with them and they said, 'We recognize we have to do this and we're not going to play around with it, because we know the risk would catastrophic.'"
But Republicans appearing on Sunday talk shows insisted they would not go along with raising the limit without a deal to rein in future deficits. "In addition to raising the debt limit we want financial controls, we want cuts in spending accompanying a raising of the debt ceiling,” said Rep. Paul Ryan, R-Wis., who heads the House Budget Committee. “And that is what I believe they (Republican congressional leaders) told the president."
Though failure to raise the debt limit would further spook investors, a large number of voters are opposed to the idea.
According to a recent NBC/Wall Street Journal poll, only 16 percent of voters said Congress should raise the debt ceiling, while some 46 percent said they were opposed. When told that would mean the U.S. could default on its debt, 32 percent supported raising the limit. But 62 percent said they opposed lifting the cap even if it meant the Treasury would not making good on its debt payments.