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S&P cuts Australia credit rating outlook to negative

Australia faces the prospect of losing its vaunted AAA rating, after S&P Global Ratings lowered its outlook on the country's debt to negative.

S&P cited a combination of the government's budget deficits and the likelihood of a political stalemate as the country awaits the outcome of what is likely to be a very close election as the reasons behind its decision.

The ratings agency said there was a one-in-three chance it could lower the country's credit rating withing the next two years if it believed parliament wasn't likely to legislate savings or revenue measures to narrow or eliminate the budget deficit by the early 2020s.

"Without the implementation of more forceful fiscal policy decisions, material government budget deficits may persist for several years with little improvement," S&P said in a statement on Thursday. "Ongoing budget deficits may become incompatible with Australia's high level of external indebtedness and therefore inconsistent with a 'AAA' rating."

S&P noted that since the global financial crisis period of 2008-2009 and the end of the mining boom, the country's government finances weakened, pushing back the prospect of returning to budget surpluses.

"Given the outcome of the July 2, 2016, double-dissolution election, in which neither of the traditional governing parties may command a majority in either house, we believe fiscal consolidation may be further postponed," it said.

The news whacked the Australian dollar, which fell as low as $0.7464 from levels as high as $0.7538 before the announcement.

Rivals Fitch Ratings and Moody's Investors Service currently rate Australia at AAA, but earlier this week, Fitch said it was concerned political gridlock could lead to an increase in the fiscal deficit, which would pressure the rating.

Counting of the votes from the weekend election wasn't completed as of Thursday. The current ruling Liberal/National Coalition had won 74 of the 76 seats needed to form a majority government, while the opposition Labor Party had 71 seats and smaller and independent parties had taken five seats, according to the Australian Electoral Commission.

At least one analyst said S&P's step wasn't surprising.

"Australia has now seen years of slippage in returning the budget to surplus and the messy election outcome threatens more slippage whichever way it goes," Shane Oliver, head of investment strategy and chief economist at AMP Capital, said in a note Thursday.

"It's probable that a formal downgrade will follow unless the new government is able to hold the line on the budget deficit projections, which will be hard given the likely state of the Senate," Oliver said, but noted that while that would be a "bad sign" for Australia, it wouldn't be disastrous.

In a note on July 5, Oliver had said the biggest impact from a downgrade would likely be "the blow to the national psyche," as it wasn't clear that a rating cut would mean investors would necessarily demand higher yields to hold government debt.

The Australian benchmark 10-year yield moved just a tad on the announcement, to 1.884 percent from around 1.874 percent before the news. That's already well above most developed market bond yields, with the 10-year Japanese government bond at negative 0.27 percent, the 10-year German bond at negative 0.1761 percent and the 10-year U.S. Treasury at around 1.365 percent.

In a meeting on Tuesday, the Reserve Bank of Australia (RBA) kept interest rates on hold at a record low of 1.75 percent amid relatively benign inflation, but analysts generally expect at least one 25 basis-point rate cut sometime later this year.

Any uptick in yield on Australia's government bonds may be met by higher demand from yield-starved investors globally. Bond prices move inversely to yields.

Indeed, in a report earlier this week, Nomura noted that demand for Kangaroo bonds -- or bonds issued by foreign companies in Australian dollars and traded in Australia -- appeared to be supporting the country's currency at levels above where the commodity prices suggested it should be. Australia relies heavily on its commodity exports and has suffered from a long slump in the sector, particularly in iron-ore prices.

Chris Weston, chief market strategist at spreadbettor IG, noted concerns that with high foreign ownership of Australian debt of 60.4 percent as of March, there may be forced selling, spurring "sizeable" fund outflows. That compares with an around 33 percent foreign ownership of U.S. government debt, as of the end of April.

But he added that when the U.S. lost its AAA rating in 2011, bond yields there actually fell, with the U.K. and France also seeing similar bond-market reactions in 2012 and 2013 respectively.

Weston said that banks Down Under could face higher funding costs if Australia's credit rating were cut, but he added that banks appeared well prepared for this.

Additionally, Capital Economics noted that Australia's banks have cut their reliance on short-term debt for funding since the global financial crisis and now relied more on domestic deposits.

"The whims of the ratings agencies will play second fiddle to the more powerful economic forces of subdued GDP growth, low inflation and low official interest rates that will keep borrowing costs low throughout the economy," Paul Dales, chief Australia economist at Capital Economics, said in a note Thursday.

Flag of Australia on a beach
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Flag of Australia on a beach

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—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1