U.S. politics threaten AAA-rating: HSBC

Despite a growing of risk of a credit rating downgrade, the U.S. remains in denial and unwilling to shake off its decade long fiscal laxity.

Rather than cutting to address the disturbing deterioration in fiscal and debt metrics, the U.S. administration remains fixated on spending, says Philip Poole, global head of macro and investment strategy, HSBC Global Asset Management (UK) Limited, in a recent commentary on American economy.

“[Standard & Poor’s] warning is the culmination of more than 10 years of U.S. fiscal laxity from a combination of tax cuts and spending increases, aggravated by the impact of deep recession, which further cut revenues and increased spending,” said Poole.

Earlier this month, Standard & Poor’s cut its outlook for the U.S. from stable to negative, signalling the possibility of a credit rating downgrade by 2013 if things don’t improve.

The move has investment implications for the U.S. and beyond which include specific and direct consequences for currencies and bond markets as investors slink back into risk-averse territory and sit out for a while.

Poole points out that development has the potential to unnerve a larger number of foreign holders of the greenback. “With roughly 50% of marketable Treasury securities held abroad, the dollar will likely be vulnerable to negative developments on the debt front,” he said.

Currencies such as the euro, the Swiss franc, gold and precious metals and even emerging market currencies could be the biggest beneficiaries of dollar weakness.

“Longer term, concern over U.S. credit quality could compromise the dollar’s position as a global reserve currency and hasten the move to a multi-reserve currency world, including increasing use of emerging currencies over time as they become more convertible,” Poole said.

Increased risk of downgrade is bad news also for Treasuries, which were fast falling out of investor favour even before the S&P announcement.

The Federal Reserve, he said, will cease to be a net purchaser of government debt once QE2 expires at the end of June, which is bound to cause concerns as to how the world’s central banks will reduce their portfolios of U.S. government debt.

“The market’s base assumption seems to be that holdings will simply erode through a process of natural decay as bonds mature and roll off,” he said. “However, unless there is a fiscal cutting program draconian enough to reduce outstanding government indebtedness (highly unlikely), the private sector will need to step up to refinance these maturing bonds.”

This dramatic deterioration in outlook reflects a lack of political will. The U.S. has been in denial about its fiscal solvency, and little is expected to change until after national elections in 2012, by which time “the coveted AAA rating will become history.”

If the rating action fails to galvanize politicians into taking action to curb expenditure and raise revenues, it will become increasingly difficult to bring deficit under control.

Poole points out potential risks include a sharp rise in interest rates from current historically low levels. Interest payments on government debt are likely to rise to 20% of federal revenues by the end of the decade.

As the debt servicing burden rises, it further reduces the room for fiscal manoeuvre and increases the need for underlying action on either the revenue or the expenditure front.

Moreover, the maturity structure of government debt has been shortening, raising the vulnerability to interest rates increases, because they have a more immediate effect on debt servicing costs.

But there are no easy solutions, says Poole, adding that “recent events have shown that there seems to be little middle ground for compromise between the main parties.”

Should S&P’s warning spur U.S. politicians into action on the deficit, there are also important implications for monetary policy. Poole says the U.S. recovery is not strong enough to deal with the withdrawal of both monetary and fiscal stimulus.

“For this and other reasons, we believe it seems highly unlikely that the Fed will allow its balance sheet to shrink when QE2 expires in June.”

It will reinvest maturing mortgage debt into Treasuries, locking in the liquidity that has flooded financial markets for some time to come, he added.