U.S. Credit Downgrade Possible, Moody's Warns

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The United States' AAA credit rating may be at risk sooner than previously thought as the nation fails to deal with its growing debt, Moody's Investors Service warned last week.

Moody's said December's extension of the Bush-era tax cuts, combined with results from the November elections, may lead to further gridlock in Congress, increasing its doubts about the federal government's determination to reduce its debt.

The credit ratings agency said it might put a "negative" outlook on the AAA rating of U.S. debt sooner than anticipated as the country's budget deficit expands.

"Although no rating action is contemplated at this time, the time frame for possible future actions appears to be shortening, and the probability of assigning a negative outlook in the coming two years is rising," wrote Steven Hess, a senior credit officer in New York and the author of the report. The rating remains "stable," according to the report.

The warning from Moody's came on the same day that Standard & Poor's lowered Japan to AA- from AA, signaling that the ratings firms are stepping up pressure on the world's biggest economies to curb their spending.

U.S. debt has increased from about $4.34 trillion in mid-2007 to roughly $14.3 trillion currently, as the government supported a massive bailout of the financial system and spent trillions in stimulus money in order to bring the economy out of recession. The budget deficit has increased to 8.8% of gross domestic product (GDP) from 1% in 2007.

"Because of the financial crisis and events following the financial crisis, the trajectory is worse than it was before," Hess told Bloomberg News in a telephone interview.

A downgrade would significantly tarnish the world's faith in U.S. Treasury bonds. That would reduce the country's ability to borrow money on extremely favorable terms.

A credit rating tells lenders and investors how likely it is that a borrower will default on a loan. A "AAA" rating means there is little for lenders to worry about. That leads to lower borrowing costs, whereas a lower rating typically results in bond investors demanding higher interest rates to take on riskier debt.

Higher rates also can expand a country's overall debt burden, forcing the government to cut spending programs and raise taxes. That conundrum was recently demonstrated by the social unrest in Greece and Portugal, as citizens marched in the streets to protest tough austerity measures that directly reduced state welfare programs and entitlements.

Even the threat of a lower rating could lead international investors to avoid U.S. assets. About 50% of the almost $9 trillion of U.S. marketable debt is owned by investors outside of the nation, according to Bloomberg's analysis of Treasury Department data.

Moody's said it expects there will be "constructive efforts" to reduce the U.S. deficit and control entitlement spending. It predicted 10-year Treasury yields would rise toward 5% but not exceed that level.

"Other large AAA countries have plans to reduce deficits substantially over the coming few years, indicating that this trend may continue," Hess said.

Congress is currently bickering over whether to raise the debt limit above $14.29 trillion, which the Treasury estimates will be reached between March 31 and May 16.

The debate over the debt ceiling, which was increased a year ago, has grown more rancorous since the November elections, when Republicans won control of the House of Representatives.

Republican lawmakers have pledged to challenge the Obama administration on spending, and have told the president and Democratic legislators that they will insist on budget cuts as a condition of raising the U.S. debt limit.

Moody's warning comes only a few days after President Barack Obama's State of the Union address, in which he called America's current situation a "Sputnik" moment.

The speech caused consternation among analysts, including Money Morning Contributing Editor Martin Hutchinson, who analyzed President Obama's speech in a column last week.

"President Obama's fascination with the 'Sputnik moment' goes way beyond rhetoric," Hutchinson wrote. "Just as the nation saw after Sputnik, President Obama wants to 'invest' more taxpayer money in research, hoping to find a new industry or two."

During the hysteria surrounding the Sputnik scare, "Congress…embarked upon an orgy of public spending," Hutchinson wrote. "At a time of zero inflation, the federal spending total for the fiscal year that ended in June 1959 was a staggering 11.7% above that of 1958, the highest peacetime increase between 1949 and the inflationary year of 1976."

And in a two-part interview last week, Money Morning Chief Investment Strategist Keith Fitz-Gerald stressed debt reduction as a fundamental piece of an eight-part plan to fix the U.S. economy.

"There's a longtime axiom among professional traders: Big Government = Small Wallets. Pure and simple," Fitz-Gerald wrote. "There is no such thing as a multiplier effect and every government dollar spent actually replaces a dollar from the private sector. The very notion that the government can spend money more efficiently than private enterprise is badly flawed and robs this country of wealth at all levels."

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