S&P Debt Downgrade Ramps Up Pressure to Resolve Budget Crisis

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When Standard & Poor's Rating Services Inc. yesterday (Monday) downgraded its outlook on U.S. debt to "negative," it sent the U.S. government a simple message: Deal with your deficits.

The rating agency expressed concern that continued dithering in Washington over how to address the $14 trillion-plus debt and ever-growing annual budget deficits would "render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA' sovereigns" - a hint the United States could lose its AAA rating.

"More than two years after the beginning of the recent crisis, U.S. policymakers have still not agreed on how to reverse recent fiscal deterioration or address longer-term fiscal pressures," wrote S&P credit analyst Nikola G. Swann.

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S&P said it will maintain its AAA credit rating on U.S. bonds for now. However, the outlook was downgraded from "stable" to "negative," meaning the firm sees a one-in-three chance that it will lower the rating within two years. The agency said it foresees a significant risk that the political battles over how to fix the nation's fiscal woes could drag on until after the 2012 elections.

"This new warning highlights the need for the U.S. to take better control of its fiscal destiny if it is to avoid higher borrowing costs and maintain its central role at the core of the global economy," Mohamed El-Erian, chief executive at PIMCO, told Reuters.

Markets reacted swiftly to the news. The Dow Jones Industrial Average plunged more than 200 points in the morning, with most major U.S market indices slipping about 1.5%. Gold prices rose 1% to $1,498 an ounce before sliding back slightly.

By midday, yields of two-year Treasuries fell five basis points to 0.65%, while the 30-year yield rose three basis points to 4.50%.

"The back end of the curve reacts clearly to inflation expectations and credit concerns, and this is clearly a credit concern," Ray Humphrey, senior portfolio manager for the TIPS, government and non-dollar sectors at Hartford Investment Management, told Bloomberg News. "It's the 30-year that definitely is going to take the brunt of this rating action."

The S&P report acknowledged the two budget plans currently on the table in Washington, from U.S. President Barack Obama and Rep. Paul Ryan, R-WI, but noted that the "gap between the parties remains wide."

Members of the Obama administration disagreed with S&P's grim assessment, offering assurances the two sides can and will cooperate on solving the country's budget problems.

"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," Mary Miller, assistant U.S. Treasury secretary for financial markets, said in the statement.

Austin Goolsbee, chairman of the Council of Economic Advisors, gave several television interviews over the course of the day saying that President Obama and Republican Congressional leaders are "pretty close" in the amount they seek in deficit reductions - about $4 trillion.

"I believe we can get to some long-term deficit reduction that would address these issues that S&P's discussing," Goolsbee told MSNBC.

Goolsbee also pointed out that Moody's Corporation (NYSE: MCO) last week retained its positive outlook on U.S. sovereign debt, saying it viewed President Obama's plan as a favorable development.

Republican leaders, however, seemed to verify S&P's concerns by issuing distinctly partisan statements.

S&P's announcement is a "wakeup call" to "stop our nation from digging itself further into debt," House Majority LeaderRep. Eric Cantor, R-VA, told Bloomberg. "House Republicans will only move forward on the president's request to increase the debt limit if it is accompanied by serious reforms that immediately reduce federal spending."

Ryan, the architect of the Republican plan, said in a statement, "House Republicans took action last week to chart a new course by passing a budget that lifts our crushing burden of debt and puts our economy on the path to prosperity. By contrast, the President's budget locks in Washington's recent spending spree, adds $13 trillion to the debt over the next decade, and accelerates our nation toward a fiscal crisis."

Then again, in challenging U.S. politicians S&P may nudge them closer to a deal.

"By saying there is a ‘material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013, S&P actually increases the chances that just such an agreement will be reached," Fidelio Tata, head of U.S. interest rate strategy at Société Générale (PINK: SCGLY), told The Financial Times.

"The best way to make Washington actually do something is to tell politicians there is something they cannot do," said Tata.

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