by Ben Baden

Experts say it could lead to higher interest rates, which could be a drag on the economy

April 25, 2011

Investors awoke Monday to two important reports on the U.S. government's credit worthiness from two of the biggest ratings agencies in the United States. Standard and Poor's downgraded its outlook for U.S. debt to negative, while Moody's Investors Service held its rating at stable.

Experts consider a downgraded outlook to be a warning that a government's debt could be downgraded in the future. In its report, S&P said: "The negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years." S&P says it's concerned that policymakers on Capitol Hill won't be able to agree on a budget solution until at least after the 2012 national elections.

S&P says policymakers need to explain how they plan to fund entitlement programs over the long term. "We view the U.S.'s unfunded entitlement programs (such as Social Security, Medicare, and Medicaid) to be the main source of long-term fiscal pressure," it said in the report. Currently, these programs account for about half of federal spending.

The concern is that Republicans and Democrats won't be able to compromise to fix long-term budget problems. "We need Congress to step up, roll up their sleeves, work together, and get something passed," says Wil Stith, manager of the MTB Intermediate-Term Bond Fund .

Moody's applauded moves by both President Obama and Wisconsin Rep. Paul Ryan, who have both offered broad plans on how policymakers should go about tackling the deficit. "We view the changed parameters of the debate, with broadly similar goals as to government debt levels, as a turning point that is positive for the long-term fiscal position of the U.S. federal government," Moody's said in its report.

Steve Van Order, fixed-income strategist for Calvert Asset Management, says this more positive news was somewhat ignored by the markets Monday. "Moody's says since the issue is on the table, it's positive," he says. For now, the markets are reacting to the news from S&P.

Market watchers are concerned that the ballooning deficit could cause interest rates in the United States to spike.Higher interest rates on U.S. debt would mean higher borrowing costs for consumers and businesses. Investors need look no further than Europe to see what can happen if the markets lose faith in a country's ability to service its debt. Yields on sovereign bonds in Ireland, Greece, and Portugal have spiked recently over concerns that those nations will not be able to fully repay their debts. "Bond investors have been pretty patient with the U.S. market, but the question is, how long does that patience last?" Van Order says. The 10-year treasury currently yields about 3.4 percent, which is low by historical terms.

Higher interest rates are generally associated with higher economic growth, but rates moving up too quickly could be devastating for the U.S. economy, says Madeline Schnapp, director of macroeconomic research at TrimTabs Investment Research. "What if [the 10-year treasury rate] spikes to 5 percent?" she says. "All of a sudden, you're looking at financing costs that are far higher than they were before, which then reduces demand, which then slows the economy. That's the problem."

There are also concerns that treasuries could lose their appeal to investors both in the United States and overseas. As the Federal Reserve winds down its latest round of quantitative easing--commonly referred to as QE2--in which in which it's purchasing $600 billion worth of treasury securities to keep rates low and help kick-start economic growth, Schnapp is concerned that foreign and domestic purchasers may decide not to buy U.S. debt at such historically low yields. "There is a big risk now that our deficits have gotten so high that there is not going to be enough buyers to purchase treasuries at existing prices," Schnapp says.

Currently, the Federal Reserve purchases about 70 percent of the total treasuries in circulation, Schnapp says. The Fed meets next week and is expected to hint at plans to end its QE2 program at the end of June. "If the Fed decides not to do any further QE2 and do a wait-and-see approach, they risk spikes in interest rates," Schnapp says.

Once a buyer as big as the Fed exits the market, economists say they're uncertain who's going to step in to fill that gap. Before QE2, the Fed only purchased about 10 percent of the total treasuries in circulation, while private domestic purchasers bought about 40 percent and foreigners purchased the other half, Schnapp says.


What Standard & Poor's U.S. Outlook Downgrade Means