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US Government Debt Downgrade?

S&P cut its AAA rating on U.S. government debt back in August of 2011 and has since had a Negative Watch. Moody's and Fitch have indicated that they could possibly cut their AAA rating if meaningful measures were not adopted that address the medium term fiscal outlook.

In my humble opinion, the Fiscal Cliff deal reached today (1/2/2013) does little to address the immediate threat of further escalation of fiscal deficits. The prospects of debt levels approaching debt ceiling levels is cause for concern and will likely impact market and rate volatility going forward.

Granted, there is a need to balance growth and fiscal deficits. To balance the deficit one can raise taxes, cut spending or do both in some form. It is that simple. The practicality of such simplicity is being tested due to the need to balance growth with long term deficit reduction. Any measures to address the deficit can put pressure on economic growth. The current fiscal policy is estimated to put a 1.5% drag on GDP due in part by the expiration of payroll tax cuts, higher taxes for the wealthy and other measures that raise government revenue. However, sequestering or meaningful spending cut measures were not part of the passed legislation. Hence, only one of two sides of the fiscal deficit balancing equation has been addressed. As a result, deficits are expected to continue growing. This may tip the scale in favor of rating agency action to downgrade U.S. ratings.

With Democrats loosing leverage now that an agreement has been reached, the House will gain increased leverage as we near the debt ceiling deadline. Spending cuts will have to be addressed and Republicans will likely wave a heavy stick on this front.

In short, S&P will likely stand pat and continue its Negative Watch on U.S. government debt, while the odds of Moody's and Fitch downgrading U.S. sovereign ratings may have picked up.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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