In a clear signal that the world's most powerful country cannot sustain huge deficits and soaring debt indefinitely without paying a heavy price, a major bond rating agency warned that Washington faces the loss of its coveted triple-A credit rating unless politicians come up with a credible plan to restore fiscal sanity.
The decision by Standard & Poor's to cut its outlook on long-term U.S. debt to "negative" is the first time the influential rating agency has raised a red flag over the worsening fiscal outlook and the political paralysis in Washington. And coming at the same time as the renewed focus on the debt troubles of euro-zone nations like Greece and Portugal, it had an instant effect on financial markets.
Bonds and equities slid on the news, erasing an earlier rally, even though the U.S. deficit woes and political gridlock have scarcely been hidden from view. Bonds later reversed course, but stocks remained lower. Every major equity index in North America fell at least 1 per cent except the S&P/TSX composite, which dropped 97 points, or 0.7 per cent.
The warning is more about politics than economics or finance. "More than two years after the beginning of the recent crisis, U.S. policy makers have still not agreed on how to reverse recent fiscal deterioration or address longer-term fiscal pressures," S&P credit analyst Nikola Swann said.
Rival debt agency Moody's Investors Service is maintaining a "stable" view of U.S. government debt for now. But both agencies have put Washington on the clock, giving politicians two years to get the nation's fiscal house in order.
Any threat to the triple-A rating is taken seriously because U.S. government debt serves as a global benchmark that influences the pricing of trillions of dollars of other debt.
"This is a timely reminder of the seriousness of America's fiscal issues, for the country and for the rest of the world," Mohamed El-Erian, chief executive officer of fund giant Pacific Investment Management Co., said in an online comment. "The continued failure to come up with a credible medium-term fiscal reform program would increase borrowing costs for all segments of U.S. society."
For now, though, the warning carries more symbolic than actual importance in the market.
Investors have continued flocking to U.S. securities, precisely because of concerns about default risks, economic slowdowns and asset bubbles elsewhere and because the United States remains by far the world's deepest and most secure market.
Washington also has no history of defaults and has an enormous capacity to boost taxes or take other remedial action that would curb the deficit - provided, of course, there is political will to do so. There is also the lure of its huge economy: The U.S. has a gross domestic product equal that of the other 18 triple-A-rated entities, including the likes of Canada, Britain, Germany and France, combined.
It seems inconceivable that big institutional investors, including foreign governments, would be able to find safer markets that could absorb vast quantities of capital, although they would undoubtedly demand higher rates at some point to compensate for the increased risk.
"While the downgrade threat is what it is, buyers shying away from U.S. debt have little other choice," said David Ader, head of government bond strategy at CRT Capital Group in Stamford, Conn.
That does not mean the S&P decision can be taken lightly, Mr. Ader said in a note. The revised outlook represents a change from previous "vague warnings (which the ratings agencies have voiced consistently) to an official stance, albeit a rather generic one. The market surely reads it as just that - something to think about down the road."
Noting that Republicans, who control Congress, and Democrats, led by President Barack Obama, remain far apart on a plan to restore a semblance of fiscal order, S&P warns of "a significant risk" that the two sides will fail to reach a deal on a medium-term fiscal strategy until after the 2012 elections. That would mean no concerted action to rein in the deficit before fiscal 2014, "and we believe a delay beyond that time is possible."
The opposing sides have each proposed plans that promise to slice the federal deficit by at least $4-trillion (U.S.) over the next 10 to 12 years. But they vehemently disagree on how to achieve the cuts.
"We're mindful of the fact that policy makers are beginning to focus on some type of fiscal agreement," said David Beers, global head of S&P's sovereign debt ratings. "Reaching a concrete agreement on a path of fiscal consolidation will be difficult … in the next two years."
S&P did not mention a more imminent financial problem - the need to raise the legislated ceiling on federal debt - which could turn into a full-blown crisis in a matter of months if Democrats and Republicans can't reach a deal.
Based on fresh projections for revenues and expenditures, U.S. Treasury Secretary Timothy Geithner has warned that the debt limit of $14.3-trillion (U.S.) will be breached by mid-May and that the government would have to default on obligations by early July unless Congress raises the ceiling, as it has done regularly for much of the past decade.
Such a dire outcome is extremely unlikely, despite sharp party differences over longer-term fiscal issues, analysts say.