The Downgrade Threat

Last month I wrote an op-ed (for our monthly issue of Ahead of the Curve) looking at President Obama’s 2012 proposed budget which projected debts rising to 100% of GDP and putting us past the range of AAA credit worthy as early as 2015. Of course, that assumed America didn’t default on its debt sooner.

Yesterday, S&P fired a warning shot across the bow of Capitol Hill by putting the US on alert that the ratings agency could consider a downgrade in the near future if Washington doesn’t get its fiscal house in line. CNBC reports:

S&P Monday surprised some investors, but not the bond market, when it changed its outlook on the U.S. to negative from stable. The ratings agency also said there’s a one in three chance it could downgrade the United States’ AAA credit rating, should the Obama Administration and Congress fail to find a way to slash the budget deficit within two years.

Shortly after the S&P comment, its rival Moody’s left its outlook for the U.S. unchanged and said the efforts for debt reduction plans point to “potential change in the direction of fiscal policy.” The bond market shrugged off the S&P comment, reacting to other factors as well as the Moody’s comment. As bond prices rose, the yield on the 10-year slipped to 3.373, its lowest level since March 23, and the 2-year fell to 0.653, its lowest level since March 21. The dollar, also in a counter intuitive move, rose on the day ending up 1.3 percent against the euro, which was at 1.4233.

The first question not addressed in the CNBC story is “why” S&P did this now. Maybe they have some inside information on GDP. Perhaps they were concerned with the President’s speech last week on the budget—which left much to be desired. They did say in a comment about their outlook downgrade, “We believe there is a significant risk that Congressional negotiations could result in no agreement.” As such, the negative outlook is likely based more in a political analysis of Washington than an economic analysis at this point.

With that in mind, it looks like the street didn’t take the warning too seriously. And they aren’t without cause, after all, we are talking about the ratings agencies that were at the heart of the financial crisis yet have gotten away with complete incompetence without much more than a bruised ego. We’ve talked on this blog extensively about ratings agency failures and at one point last year it looked like Congress was a lock to fix the problem—but 11th hour changes to Dodd-Frank left the failed rating agency oligarchy system in place for now.

However, even though they lack some credibility, their word can still move markets. Whether or not it would be the right decision to make, a downgrade of US debt could be catastrophic. What that looks like is hard to really know—which is why it is easy to make doomsday predictions but harder to respond substantively. Nevertheless, this warning from S&P should make the need for substantive budget reform—addressing long-term debt not just short-term deficits—all the more important on Capitol Hill. And that is a good thing.

For more, see Downgradocalypse 2015.