U.S. credit outlook lowered by S&P on deficit fears

By Steven C. Johnson Steven C. Johnson – 17 mins ago

NEW YORK (Reuters) – Standard & Poor's slapped a negative outlook on the United States' top-notch credit rating on Monday, jacking up the pressure on the Obama administration and Congress to slash the yawning federal budget deficit.

S&P, which assigns ratings to guide investors on the risks involved in buying debt instruments, said the move signals at least a one-in-three chance that it could eventually cut its long-term AAA rating on the United States within two years.

A downgrade, which would leave Germany and France with a higher rating, would erode the status of the United States as the world's most powerful economy and the dollar's role as the dominant global currency.

As investors demand higher returns for holding riskier U.S. debt, the resulting rise in bond yields would crank up borrowing costs for consumers and businesses. That would threaten to hurt the economy as it recovers from the worst recession since World War II.

"This new warning highlights the need for the U.S. to take better control of its fiscal destiny if it is to avoid higher borrowing costs and maintain its central role at the core of the global economy," said Mohamed El-Erian, chief executive at PIMCO, which oversees $1.2 trillion in assets.

After the S&P announcement, longer-dated U.S. government bond prices rose while major U.S. stock indexes shed more than 1 percent. But the dollar held gains against the euro.

The cost of insuring Treasury debt against default neared a 2011 high, though it stayed well below lofty levels reached in March 2009 when fears of a double-dip U.S. recession raged.

BUDGET BATTLE

The threat of a downgrade raises the stakes in the current struggle between President Obama's Democratic administration and his Republican opponents in the House over to get control over a nearly $1.5 billion budget deficit and $14.27 trillion burden of outstanding debt.

The White House last week announced plans to trim $4 trillion from the deficit over the next 12 years, mostly through spending cuts and tax hikes on the rich. Congressional Republicans want deeper spending cuts and no tax increases.

The deficit problem has become crushing since the financial crisis of 2008. Now for every dollar the federal government spends, it takes in less than 60 cents in revenue.

A budget deficit running at nearly 10 percent of output and expected to grow will likely further swell a public debt load that's already more than 60 percent of the country's gross domestic product.

"Because the U.S. has, relative to its AAA peers, what we consider to be very large budget deficits and rising government indebtedness, and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable," S&P said in a release.

Even so, White House Economic Adviser Austan Goolsbee on Monday downplayed S&P's move, telling CNBC it was a "political judgment" that "we don't agree with."

DoubleLine Chief Executive Jeffrey Gundlach said on Monday that the S&P warning "should serve as an effective cattle prod in pushing the politicians toward a program of spending cuts and tax increases."

"It's a wake-up call that we need to do something," said Axel Merk, president and portfolio manager of Merk Hard Currency Fund in Palo Alto, California. S&P is "absolutely correct that this is something serious that needs to be addressed."

For PIMCO, the world's largest bond fund, the picture had become bleak enough to prompt it to announce in February it had sold all U.S. Treasuries in its $236 billion Total Return Fund.

Bill Gross, PIMCO's chief investment officer, said he expected interest rates to climb, the dollar to fall and the United States to lose eventually its AAA credit rating.

A top administration official on Monday reiterated U.S. commitment to act and said S&P underestimated that resolve.

"We believe S&P's negative outlook underestimates the ability of America's leaders to come together to address the difficult fiscal challenges facing the nation," said Mary Miller, assistant Treasury secretary for financial markets.

But S&P said neither the White House nor Republican plan does enough to fix the shortfall, and the tension between the parties has cast doubt on whether they will be able to work together on a long-term solution.

"Looking at the gulf between the parties, it has never been wider than now," David Beers, S&P's global head of sovereign ratings, said on Monday. "It takes a lot of political will to bridge this gulf."

Last week, a U.S. congressional report last week blamed ratings companies such as S&P and Moody's Corp for triggering the financial crisis when they cut the inflated ratings they had applied to complex mortgage-backed securities.

George Feldenkreis, CEO of Perry Ellis International, said that casts doubt on S&P's outlook.

"The same S&P that recommended subprime mortgage insurance and is responsible, together with Moody's, for everything that happened in 2008, does not have the intellect or systems to judge the ability of the U.S. economy or political system to resolve its issues of taxation and needed budget cuts," he said.

Moody's put some issues of U.S. Treasury debt on watch for a downgrade in 1996 when the White House and Congress temporarily failed to extend the government's debt ceiling.

The two sides are heading for a similar showdown over the $14.3 trillion legal borrowing limit, which will have to be extended within weeks.

David Joy, chief strategist at Columbia Management, which oversees $347 billion in assets, said, "Hopefully, today's ratings action will underscore the urgency of deficit reduction among the members of Congress."

WATCHING WASHINGTON

The U.S. debt burden has grown exponentially after a housing bubble burst in 2007 and set off a world financial crisis that toppled several Wall Street banks, drove up the jobless rate and thrust the global economy into recession.

Governments around the world were forced to increase public spending to prevent their economies from lurching into an even worse depression.

The tactics helped spark a recovery but left the United States and other advanced economies, which were hit hardest by the crisis, with staggeringly large debt burdens.

Moody's Investors Service, which reaffirmed the U.S. top credit rating on Monday, said the fact that the issue was being taken seriously by lawmakers was positive, "although it remains uncertain what sort of budget will actually be adopted."

The U.S. dollar managed rise on Monday, and traders said debt problems in some Greece and other European countries were hurting the euro.

Even so, the greenback is down about 5 percent against major currencies in 2011, and record low interest rates together with the S&P move will do little to make it more attractive, said Kathy Lien, director of research at GFT.

"Even though I don't think an actual downgrade would occur, in this very sensitive or vulnerable time for the U.S. dollar, it's enough to spook investors from holding or buying U.S. dollars," she said.

(Additional reporting by Richard Leong, Jennifer Ablan, Herb Lash, Wanfeng Zhou and Frank Tang; editing by Frank McGurty)