U.S. credit outlook cut by S&P on deficit concerns

U.S. credit outlook cut by S&P on deficit concerns

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By Steven C. Johnson

NEW YORK | Mon Apr 18, 2011 2:19pm EDT

NEW YORK (Reuters) - Standard & Poor's slapped a negative outlook on the top-notch credit rating of the United States 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 cut its long-term rating on the United States within two years.

A downgrade would further undermine the status of the United States as the world's economic powerhouse. It would also push up mortgage rates and tighten credit conditions across the economy, possibly derailing a U.S. recovery 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.

Longer-dated U.S. government bond prices fell, while major U.S. stock indexes shed more than 1 percent. But the dollar held gains against the euro.

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

The move will push the Obama administration and Congress to work harder to come up with an aggressive long-term plan to cut a nearly $1.5 trillion federal budget deficit, equal to about 9.8 percent of output.

"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."

TROUBLE FOR TREASURIES

Outstanding public U.S. debt has swelled to more than 60 percent of total output in the aftermath of the 2007-2009 financial crisis. With a budget deficit running at nearly 10 percent of output and expected to grow, that total is expected to swell further.

"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.

The picture had become bleak enough to prompt PIMCO, the world's largest bond fund, 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.

The Obama administration last week announced plans to trim $4 trillion from the budget deficit over the next 12 years, mostly through spending cuts and tax hikes on the rich.

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.

"I don't think that we should make too much out of that," added top White House economist Austan Goolsbee said on MSNBC, referring to the S&P downgrade.

"What the S&P is doing is making a political judgment and it is one that we don't agree with," he said on CNBC.

The White House and Congressional Republicans have clashed over their respective plans to cut the budget, with the latter pushing for even deeper cuts and no tax increases.

But S&P said neither plan does enough to fix the shortfall, and the tension 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," Beers said. "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.

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 U.S. 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 "credit positive, although it remains uncertain what sort of budget will actually be adopted."

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."

The U.S. dollar managed to hold gains against the euro on Monday, and traders said debt problems in some European countries were lending some support to the U.S. currency.

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.

(Editing by Frank McGurty)

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