U.S. debt: Not off the hook yet

Debt Crisis Update

Obama signs debt deal, default averted

Washington may have reached a deal on its debt ceiling, but it still can’t catch a break from ratings agencies.

Moody’s Investor Services has re-affirmed the U.S. government’s Aaa rating, but has changed its outlook on the world’s biggest economy to “negative”. Moody’s had placed the rating under review on July 13.

U.S. government bonds could be downgraded under four conditions:

– there is a weakening in fiscal discipline in the coming year;

– further fiscal consolidation measures are not adopted in 2013;

– the economic outlook deteriorates significantly; or

– there is an appreciable rise in the U.S. government’s funding costs over and above what is currently expected.

Moody’s pointed out that while the debt deal signed on Tuesday included triggers for additional spending cuts, such a system is untried.

“Attempts at fiscal rules in the past have not always stood the test of time. Therefore, should the new mechanism put in place by the Budget Control Act prove ineffective, this could affect the rating negatively,” the company warned.

On the second point, Moody’s predicts that the government’s debt-to-GDP ratio will not rise above its projected 2012 level of 73%, and should decline by mid-decade. But political gridlock could hamper these efforts.

Perhaps the most likely to triggers a downgrade is an economic decline. The first half of 2011 has not been stellar, and Moody’s questions whether a sustainable recovery will take hold within the next year or two.

The final challenge will be in avoiding increased cost of debt service.

“While Moody’s and economic forecasters generally expect interest rates to rise over the next few years, a rise in borrowing costs above and beyond what is now expected would threaten efforts at fiscal consolidation,” Moody’s warns. “Such a development would also be negative for the rating should it occur.”