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Debt Downgrade Threat Could Be the Kick US Politicians Need

Standard and Poor's warning that the U.S. may not be able to get its fiscal house in order in time to avoid a credit downgrade could provide some of the push that politicians need to work out a credible deficit reduction plan.

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 counterintuitive move, rose on the day ending up 1.3 percent against the euro , which was at 1.4233.

"The good news is it does sound like Congress is starting to take it seriously. The timing of this watch list move really underscores how important this action is going to be for fiscal reform.. One reasons is because they did it now, but also its relevance is increased because of the context of debt ceiling discussions as well." -Fixed Income Strategist, Lord Abbett, Zane Brown

"The fact that the rating agencies took a shot over the bow means there's a possibility the U.S. can get its house in order," said Alan Ruskin, head of G-10 foreign exchange strategy at Deutsche Bank. "...If authorities respond responsibly, maybe it's just the kind of jolt that would be positive for the dollar."

Ruskin said the dollar was reacting to other factors including worries about European sovereign debt and a risk-off trade. "The story would tend to be a headline that the market can think about, but there's no additional play. There's no immediate sequel. Now the ball's in the U.S. fiscal agencies' and politicians' court. The ball will be there for the next year. Let's see what happens after that. It's not going to be one news item after another on this. It's highly relevant on a multi-year basis. It's a theme, but it's not a thing that's going to be headline after headline right now," he said.

The S&P move comes as Republicans and the Obama Administration quibble over the best way to reduce the budget deficit, with each offering plans to trim $4 trillion. There is also a quickly approaching May deadline by which Congress must extend the U.S. debt ceiling. Failure to raise the debt limit would result in sovereign default though Treasury Secretary Timothy Geithner said he is confident Republicans will vote to raise the limit.

David Ader, chief Treasury strategist at CRT Capital, said concerns about the debt ceiling is one of the reasons for the buying in Treasurys. "I think that's an underlying theme," said Ader. "The bottom line is we're probably not going to do it." But he said if Congress did fail to raise the limit, an outcome would be that the Treasury would immediately stop new auctions, creating demand elsewhere.

He also said the bond market was responding to elections in Finland, which put the minority party into power. The "True Finns" oppose sovereign bailouts and that cast doubt on Portugal's bailout and efforts to help other euro zone countries.

The S&P move though threw cold water on the stock market, even if it did not affect bonds. The Dow was down 140 at 12,201.

"You would think, in fact, that the fixed income market would go the other way and in fact you look at the credit default swaps and they do reflect concern that indeed S&P may have to downgrade the United States," said Zane Brown, who heads fixed income strategy at Lord Abbett. "They moved to 49.3 from 42.3 ... It's reflecting the concern that S&P has and that others have as a result of the S&P credit watch. It should not be surprising. We've known this is a serious problem for a long time.

"The good news is it does sound like Congress is starting to take it seriously. The timing of this watch list move really underscores how important this action is going to be for fiscal reform.. One reasons is because they did it now, but also its relevance is increased because of the context of debt ceiling discussions as well," he said.

Brown said the market now expects to see at least a $4 trillion plan. "The question is can it get done in time. I also think if you poll financial institutions and investors, fiscal reform is only credible if entitlement reform is addressed. People won't believe it's a credible plan if entitlements are not part of the solution. It helps force some of the moves. It helps keep the issue in the headlines," he said.

Questions? Comments? Email us at marketinsider@cnbc.com

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