The US Debt Problem

The old saying “be careful what you wish for” holds true in the investment world at times...such as now.

In the past several days, the stock market enjoyed its best rally in months. This occurred on the back of relief from investors that the Greek debt crisis is resolved, at least temporarily.

But now that the crisis is past, what happens next?

Most likely, the major global players in the bond and currency markets will shift their attention away from Europe and towards the elephant in the room.

That elephant in the room is the United States, its humongous debt, and whether that debt will be downgraded from its current AAA rating.


Treasury Market


During the European crisis, the Treasury market once again served as a “safe haven” for many investors. But now with politicians in Washington bickering about raising the debt ceiling, some investors have left that “safe haven” and Treasury yields are on the rise.

The question is whether the trickle of investors dumping Treasuries turns into a flood.

There are certainly reasons to worry about the nation's debt. The size of the US Treasury market – the amount of debt issued – has more than doubled since 2007. And the Congressional Budget Office (CBO) stated that the country faces a “daunting” budget outlook.

The ratio of US debt to the size of the US economy will approach 100 percent this year. The CBO projects that, without significant policy changes, the federal debt will reach nearly 200 percent of gross domestic product by 2035...a very Greek-like number.

These projections of the long-term position of US debt are what prompted Standard & Poor's in April to revise its outlook on the US credit rating from “stable” to “negative”.


Overseas Rating Agencies


US rating agencies are, however, behind their peers overseas on the outlook for US debt. Several overseas debt rating agencies have already downgraded US debt.

The German credit rating agency Feri downgraded US debt in June from AAA to AA. The reasons it cited were high public debt, inadequate fiscal measures and weaker growth prospects.

The Chinese credit rating agency Dagong downgraded US debt to AA last summer. But now they have taken it a step further.

Dagong now says that the United States has already defaulted on its debt. A Dagong press release said, “In our opinion, the United States has already been defaulting...Washington had already defaulted on its loans by allowing the dollar to weaken against other currencies – eroding the wealth of creditors, including China.”

The default comment is an exaggeration, but they certainly see clearly the Federal Reserve's policy of debasing the US dollar over time.


Will a Downgrade Happen?


The question of a downgrade on US debt by US rating agencies is not simply a theoretical one. If it happens, it will cost investors a bundle.

According to a study from S & P's Valuation and Risk Strategies, a research arm of Standard & Poor's, if US debt is downgraded it will cost investors owning Treasuries a total of up to $100 billion.

Will a downgrade happen? Bill Gross of Pimco – perhaps the most famous bond investor ever – must think so. He has been very vocal over recent months about the United States' long-term fiscal position and has turned negative on US government debt.

However, most investors appear to be very comfortable about US debt and are not worried at all about a downgrade. That is why Treasury yields are so low.

They are probably right. It is doubtful that US rating agencies will bite the hand that feeds them.