Rating agency Standard & Poor's warned on Monday that it might cut rating on US government debt because of bulging budget deficits.

S&P has broken ranks with what is a political call, suggesting a one-in-three chance that the US government will be unable to halt an unsustainable debt trajectory over the next two years, IHS Global Insight Director of Sovereign Risk Jan Randolph commented in a note.

For over 70 years the United States has been widely considered AAA top-notch benchmark sovereign risk. Standard & Poor (S&P)'s decision to impose a negative outlook now puts this status under question for the first time, reflecting the unsustainable debt trajectory and risks of policy response gridlock, Randolph wrote in a note.

Though the warning gives nothing new in terms of numbers, it has rattled investors by re-highlighting the continued sovereign debt risks in the US and other advanced economies in the wake of the 2008–09 financial crisis and recession, Randolph said.

He also noted that S&P's timing is somewhat odd as it comes at a time when there are more positive signs that politicians are ready to rise to the challenge.

The following is the full text of Randolph's analysis of S&P's warning on US government debt.

Negative Outlook Reminds Investors About Unsustainable Pubic Debt Trajectories

This rating action is primarily a warning shot to Washington D.C., aimed at a political and policymaking audience. Financial investors should not be surprised, most will be fully aware of the United States' double-percentage-digit fiscal deficit, which is driving the public debt trajectory above 100% of GDP.

There is nothing new to reveal in the actual numbers; unlike the structured finance debacle, the US debt markets are quite transparent. Combined US public net debt—municipal, state, and federal—is now around USD14.2 trillion, and will this year breach 100% of GDP.

US net public debt is currently growing at just under 10% per annum, and with nominal GDP growth far below this, solvency indicators will continue to deteriorate if nothing is done. Only by generating a primary budget surplus, before interest payments on debt, will the upward trend be arrested. Conventionally, rating agencies have to provide good reasons why an AAA sovereign should retain an AAA rating when it carries higher levels of debt than its AAA peers—which typically have net public debt at less than 100% of GDP. S&P has simply shone the torch at the elephant in the room—US debt.

US and Global Markets Take a Hit, But US Dollar and US Bond Yields Remain Steady

There was an interesting divergent market reaction to the news of S&P's negative rating action—US government bond yields and the US dollar actually rose slightly. What should be read into this? Not that the US doesn't have a growing debt problem (it does), but that the nature of the key investors in US public debt are now sovereign or sovereign-related.

In rank order they are: the US Federal Reserve; Chinese state investors; and Japanese sovereign and other Asian sovereign or sovereign-related investors. Combined, these sovereign investors carry over half of US federal debt. This says more about exchange-rate policies, and that the US dollar is still currently the only real place to park governments' hundreds of billions of foreign-exchange reserves. This is despite the negative real yields and downside currency risks. However, the S&P rating action will probably confirm foreign creditor—especially Chinese—wariness and re-invigorate the search for alternative investments as well as fundamental policy examinations.

Odd Timing

While S&P's warning is not surprising, the timing of the switch to Negative outlook is rather odd. It comes amid some more positive political signs for the longer term fiscal outlook; the debt issue is now the dominant political narrative for both major parties.

However, S&P has maintained consistency in their fundamental analysis: they made exactly the same Negative rating outlook rating action for the UK sovereign a year ago. The UK had a very similar double-percentage-digit fiscal deficit (of GDP), as well as a similar net public debt starting level before the 2008–09 financial crisis and subsequent recession, together with a debt growth trajectory heading quickly towards 100% of GDP. The UK financial and political establishment took fright from the Greek crisis in March 2010, and the newly elected UK coalition government adopted the fiscal austerity that was sweeping through Europe at the behest of Germany.

The UK decided it was better to tackle the debt before the bond markets imposed a country risk premium. This means a higher interest rate risk spread above top-drawer AAA borrowers at each debt refinancing stage, as is the case for Greece, Ireland, and Portugal. At this stage, it becomes very difficult to get out of the debt hole. The US certainly has more time on its side; but no-one really know for how long. Besides, unlike the UK, the US has key sovereign investors motivated by policy reasons, for the time being.

Outlook and Implications

The irony is that this warning shot rating move by S&P is likely, if anything, to increase the chances of political and policy resolution further down the line by refocusing political minds on the deficit and debt issues.

This may help to pre-empt an actual rating downgrade. As such, the S&P rating call can be interpreted as political. IHS Global Insight maintains its own AAA Stable outlook for the US for the time being, but any AAA rating has to be earned; it is not set in stone or god given. The US AAA rating has being subject to ongoing downside pressures from recurrent annual double-percentage deficits (of GDP) and consequent public debt build.

These trends are not dissimilar to most other investment-graded sovereigns since 2008. The scars from the 2008 financial crisis and subsequent 2009 recession remain in place and continue to weigh heavily on rising public debt, with consequent drags on GDP growth in much of the West. The re-emergence of policy gridlock within the Washington administration could still trigger an IHS US Negative rating outlook switch to follow S&P, unless US politicians heed the warnings.