Debt Downgrade: Wall Street Won’t Tolerate Inaction
By JAMES C. COOPER,
Posted: April 20, 2011
Wall Street’s negative reaction to Standard & Poor’s downgrade of its U.S. government credit outlook from “stable” to “negative” on Monday made one thing perfectly clear: The markets have little tolerance for an ideological debate when potentially higher borrowing costs threaten economic growth and profits and will not hesitate to force a resolution to the current fiscal debate in Washington.
Wall Street knows that the rating agency has drawn a line in the sand. S&P’s decision to downgrade its outlook essentially gives Washington until shortly after the 2012 elections to come up with an “agreement on a comprehensive budgetary consolidation program” that cuts deficits over the next decade in line with the $4 trillion-to-$6 trillion currently proposed, combined with “meaningful steps toward implementation by 2013.” If not, it says, a downgrade of the coveted triple-A rating is possible.
It’s a tall order, given the political polarization and the structural nature of the long-term fiscal issues, but Wall Street seems willing to take a chance—for now. A day after the downgrade, stock and bond markets actually ticked up. Treasury Secretary Tim Geithner told Bloomberg TV on Tuesday that he was reasonably confident lawmakers could at least lock in what they agree on -- “the importance of putting in place strong targets for savings, for deficit reduction over a specific timeframe, with enforceable limits,” he said.
The markets still seem to believe that Europe’s debt problems are a much more immediate than those in the U.S. On the day of S&P’s decision, rates on U.S. credit default swaps, a kind of market-based insurance on debt securities, rose only slightly, a tiny negative reaction compared with far costlier swaps on the sovereign debt of Greece, Ireland, Portugal, Spain, and Italy. Analysts at UBS think S&P’s decision is jumping the gun, and adoption by Congress of specific triggers for enforceable deficit reduction, even without specifying the roles of spending and taxes, would be an important step that would ease market concerns.
The immediate problem is that the S&P downgrade comes when the U.S. is only weeks away from hitting its debt ceiling that by law limits new borrowing. Analysts at Barclays Capital note that S&P made no mention of the debt ceiling, which means the debt limit has nothing to do with the agency’s negative outlook, but it may have a lot to do with how the markets behave in coming weeks. As the limit approaches without movement toward some kind of agreement, Wall Street and foreign holders of U.S. debt are sure to demand higher yields on Treasury debt as compensation for uncertainty about the U.S. government’s commitment to meet its obligations.
The best news is that in the past several months a consensus is beginning to emerge in Washington on both what and how much needs to be done. However, as Geithner said, “ultimately people judge us by what we do, not by what we say.” On Monday, S&P and Wall Street told Washington, it’s time to stop talking and start doing, or pay the price of inaction.