By Kathleen Brooks, Research Director,

The U.S. may have avoided an immediate downgrade from the major credit rating agencies after narrowly escaping a default on August 2, but as the deal currently stands it may only be a matter of time before its rating is slashed.

China has already done it. Prior to the deal, Dagong Global Credit Rating Company rated the US A+; it was cut to A in the wake of the debt deal. And while Moody's may have affirmed the U.S. at triple A, it is on negative watch.

Credit Cut Justified
Dagong's justification for cutting the U.S.'s rating is that the deal does not fundamentally alter the public debt dynamics, in other words the U.S. is still spending too much borrowed money. It also rightly added that raising the debt ceiling by a further $2.4 trillion to $16.7 trillion will only make the U.S.'s fiscal position worse.

China is a central player in the U.S.'s debt drama. It is the largest foreign holder of Treasuries (only the Federal Reserve holds more) and has more than $1.5 trillion in forex reserves. For China the U.S. is no longer risk free. Since China has huge exposure to the U.S., when its rating agency sounds a warning note on the sustainability of the U.S. debt dynamics the world should take note. This is one of the reasons the announcement of a deal did not cause a euphoric reaction from the markets.

Will the Cuts Work?
The $2.1 trillion of cuts to public spending over the next 10 years could aggravate problems in the U.S. economy even more. There are no new sources of revenue coming into the Treasuries coffers (the Republicans refused to agree to tax increases for the wealthy) and there has been no cut to entitlement programs (something that may help to boost Democrat popularity). As you can see this was a deal with political rather than economic gain.

So where will the cuts come from? The answer is discretionary spending. That means there will be no more money for infrastructure and other government-sponsored programs (outside of Social Security, Medicare and Medicaid) to create much-needed jobs for Americans. The economy has already had a deeper recession and more shallow recovery than first thought and we are entering another slow patch – the economy grew at a dismal 1.3% rate in the second quarter.

Long-Term Problems
The U.S. is cutting money where it is most needed, and continuing to ignore the bigger problem of entitlement spending. The extent of this problem is huge, and is only getting bigger. Social Security in the U.S. is the world's largest public spending program. 2010 was a crucial year; it was when the US started paying out more money than it took in as the baby boomer generation reaches retirement age. This means the government has to borrow today to ensure retirees get their monthly cash deposit. As life expectancies grow, so too do the U.S.'s pension bills.

Estimates suggest that the unfunded liabilities of social security could be a gargantuan $16 trillion by itself, larger than the overall size of the U.S. economy. Medicare and Medicaid are even more. But while the social security/ Medicare nightmare has been brewing for some years, earlier this month the US politicians had a real chance to do something about it. Instead of taking bold action during the debt ceiling debate, the politicians' took the easier route. Undoubtedly it will be hard to take back from people what they been promised for decades. Also, Americans have been paying into social security during their working years and being told the U.S. can't afford it anymore won't stick. But rather than deal with reality, politicians on Capitol Hill instead did a very good job of protecting themselves at the next election. This move is likely to cost the U.S. its top credit rating in the long-term.

What Does It Mean for the Markets?
The knee-jerk reaction from a U.S. ratings downgrade is debatable. Treasuries remain the most deep and liquid credit market in the world. Large investors don't have an alternative to U.S. debt; for example, there is no market that could accommodate China's massive investment outside of Treasuries. So the irony of the situation is that the U.S. may remain the world's "safe haven" almost by default – because there is no alternative available right now.

This could limit the sell-off in U.S. debt, and Treasury yields may not spike even though a downgrade would show a decline in confidence that the U.S. can repay its debts. Ultimately gold is likely to be a big winner since it is not associated with a country that issues bonds.

The outcome for the USD is harder to predict. In the long-term the greenback may actually benefit. The most recent downgrade to a major developed economy was the 2002 S&P downgrade of Japanese sovereign debt. In the years following Japan's downgrade, JGB 10 year yields rebounded about 75 basis points from their lows and JPY strength ensued as USD/JPY traded down from the 120.00s to the 100.00s. Although past performance does not always predict future moves, the possibility for a similar USD reaction cannot be dismissed.

Added to that, the last time the U.S. government closed down over an impasse on a budget bill back in 1995 and 1996, Treasury yields rose from 5.5% to a high of 7% before falling back to around 6.5% at the end of 1996. The USD followed Treasury yields higher.

Bottom Line
No one knows the true cost of entitlement spending and politicians seem unwilling to reform the system to make it more affordable. This is most likely to be dollar negative because it will keep adding to the U.S.'s fiscal deficit going forward. So while credit rating agencies may have mostly left the U.S. alone this time, without reform the U.S.'s lauded social safety net could be the undoing of the world's largest economy.

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