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Why US Debt Rating Poses Such a Big Worry to Investors

Friday, 22 May 2009 | 4:07 PM ET

Even if a downgrade in US credit is not imminent, the underlying conditions that raised such fears are worrying investors about what the future holds.

Kathy Willens

The move Thursday by Standard & Poor's to cut Britain's credit outlook has raised fears that the US may be next.

Should that happen, the news likely wouldn't be good for stocks, while the dollar and Treasury prices would dip and gold probably would benefit as an investment of last resort.

While a number of experts, including Moody's, largely dismissed such concerns at least for the short term, market experts were leery of what could happen down the road should the country continue to pursue its current debt policies.

"We are heading down a virtually irreversible road where the overall financial picture of the US is going to look very bad," said Peter Tanous, president and director of Lynx Investment Advisory in Washington, D.C.

"Is this something to worry about or dismiss? Clearly, it's something to worry about," says Tanous. "In normal times nobody cares, because we're good for it. This time is different because the numbers are getting scary."

The sheer magnitude of the numbers being bandied about is causing some investor fear.

"All of this translates into hell of a big financial mess that will indeed affect US credit," Tanous said. "I've been in the business for 40 years and I've never used the world trillion before until recently. Unfortunately, it's trillions of dollars we don't have."

Boatloads of US debt in the hands of foreign governments and the myriad problems that can cause, primarily in the form of higher interest rates down the road, are causing the most concerns.

As the US continues to issue Treasury notes, there is concern that China and other large debt holders will demand higher yield, sending interest rates up for borrowers and further hampering a real estate recovery.

"At some point the market is going to extract a penalty because you're essentially putting the US government credit on the line in so many areas at such a great cost," said Mike Larson, analyst at Weiss Research in Jupiter, Fla. "You're seeing the ramifications of such short-sighted thinking."

Larson has been warning of a Treasury bubble popping since late 2008 and said the most recent conditions are further signal that US government debt prices are on a precipitous track lower, and yields will move higher. Prices and yields move in opposite directions.

China has been relied on to buy debt, but a New York Times report Thursday indicated the nation is becoming more selective in buying Treasurys and is moving towards the lower end of the yield curve, a possibly ominous sign for the long-term state of US financial health.

Continuing prospects for government bailouts also are raising concern.

"You have to really start asking yourself whether the cure is worse than the disease," Larson said. "The real danger is this trend accelerates and gets out of control. It's a risk that everybody's sort of keeping in the back of their minds, that we start to see more manifestations of the flat-out repudiation of US assets."

Beyond that, there is concern about what the debt will mean to the government's budget and how those bills will be paid by future generations.

For investors, the end result is caution that springs from an uncertain world where economic weakness pervades and government budgets crumple under their own weight.

El-Erian on the Selloff
Mohamed El-Erian, CEO and co-CIO of Pimco, discusses this week's market selloff and the possibility of the U.S. losing its AAA credit rating.

"It's going to make funding more expensive. It almost becomes a death spiral, which might be a little overdramatic, but it presents some problems," says Uri Landesman, head of global growth strategies at ING Investment Management in New York. "They way they're running things now certainly is not geared towards keeping a respectable credit rating."

Fears of what will happen to the US credit rating came to the forefront Thursday after Pimco co-CEO Bill Gross said the nation was in danger of going the same route as the UK and losing its credit rating. Pimco runs the world's largest bond fund and Gross has been an influential voice in the shaping of monetary policy here and abroad.

Speaking on CNBC earlier Friday, Gross' counterpart, Mohamed El-Erian, said investors were satisfied that the government had stemmed credit and liquidity problems in the short term but were worried about long-range ramifications.

"All of us have to worry about unintended consequences of policy action as well as the intended consequences," El-Erian said. "Every sector is having this tug of war between what it has been doing, what it ought to be doing and what people expect it to be doing."

The fragility of investor confidence went on full display Thursday after Gross' comments, when equities, Treasurys and the dollar all sold off while gold went upward.

"When the market starts to disbelieve something, the selling can turn violent," Art Cashin, director of floor operations at UBS, told CNBC.

Yet the markets turned around a bit Friday, edging higher as investors sought out positions ahead of the extended Memorial Day weekend.

Indeed, investors if nothing else, have been resilient since the rally off the March lows, and even talk of the US losing its vaunted credit rating wasn't enough to spoil the holiday optimism.

"The market will go down the day of the week that any of these countries are downgraded," Landesman said. "I don't think this fear is going to prevent a market rally if the economy continues to recover and people think the worst is behind us. It will be a glitch in the road."

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