The United States lost its top-tier AAA credit rating from Standard & Poor's on Friday in an unprecedented blow to the world's largest economy in the wake of a political battle that took the country to the brink of default.
S&P cut the long-term U.S. credit rating by one notch to AA-plus on concerns about the government's budget deficit and rising debt burden. The action is likely to eventually raise borrowing costs for the American government, companies and consumers.
"The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics," S&P said in a statement.
The outlook on the new U.S. credit rating is "negative," S&P said in a statement, indicating another downgrade was possible in the next 12 to 18 months.
The move reflects the deterioration in the global economic standing of the United States, which has had a AAA credit rating from S&P since 1941, and it could have implications for the U.S. dollar's reserve currency status.
"The global system must now adjust to the many implications and uncertainties of the once-unthinkable loss of America's AAA," said Mohamed El-Erian, co-chief investment officer at Pacific Investment Management Co which oversees $1.2 trillion in assets.
The decision follows a fierce political battle in Congress over cutting spending and raising taxes to reduce the government's debt burden and allow its statutory borrowing limit to be raised.
On August 2, President Barack Obama signed legislation designed to reduce the fiscal deficit by $2.1 trillion over 10 years. But that was well short of the $4 trillion in savings S&P had called for as a good "down payment" on fixing America's finances.
The political gridlock in Washington over addressing the long-term fiscal problems facing the United States came against the backdrop of slowing U.S. economic growth and led to the worst week in the U.S. stock market in two years.
The S&P 500 stock index fell 10.8 percent in the past 10 trading days on concerns that the U.S. economy may be heading into another recession and because the European debt crisis has worsened.
Treasury bonds, once indisputably seen as the safest security in the world, are now rated lower than bonds issued by countries such as Britain, Germany, France or Canada.
U.S. TREASURY QUESTIONS CALCULATION
Obama was briefed earlier in the day regarding S&P's intentions, but discussions only took place with Treasury officials and did not include the White House, a source familiar with the discussions told Reuters.
Late on Friday, the Treasury said the rating agency's debt calculations were wrong by some $2 trillion.
S&P confirmed it changed its economic assumptions after discussion with the Treasury Department but said it did not affect its decision to downgrade.
"We take our responsibilities very seriously, and if at the end of our analysis the committee concludes that a rating isn't where we believe it should be, it's our duty to make that call," David Beers, head of sovereign ratings at S&P, told Reuters.
The theme running throughout S&P's analysis is the breakdown in the ability of the Democratic and Republican parties to govern effectively.
The agency said that policymaking and political institutions had weakened in the past few months "to a degree more than we envisioned." This has major implications for the nation's budget and debt problems.
For example, S&P now assumes that tax cuts brought in under President George W. Bush in 2001 and 2003 would not, as planned, expire by 2012 because of staunch Republican opposition to any measure that would raise revenues.
The compromise reached by Republicans and Democrats this week calls for creation of a bipartisan congressional committee to find $1.5 trillion of deficit cuts by late November, beyond the $917 billion already identified.
While the downgrade is a blow to U.S. prestige, it was largely expected and may not have a big impact on trading of U.S. Treasuries and other assets when markets reopen in Asia on Monday.
In fact, Treasuries have rallied this week, driving the yield on the benchmark 10-year note to 2.34 percent, its lowest level in about 10 months. This reflects a belief among investors that U.S. government debt is still a safe bet at a time when prices of stocks and commodities are falling on concern about slowing global economic growth.
"To some extent, I would expect when Tokyo opens on Sunday, that we will see an initial knee-jerk sell-off (in Treasuries) followed by a rally," said Ian Lyngen, senior government bond strategist at CRT Capital Group in Stamford, Connecticut.
But the downgrade has implications for the country's financial sector, ranging from insurance companies to government-related firms such as housing financiers Fannie Mae and Freddie Mac.
"At least initially, the impact on the market will be negative because there will some forced liquidation of U.S. assets," said Boris Schlossberg, GFT director of currency research.
The downgrade could add up to 0.7 of a percentage point to Treasuries' yields over time, increasing funding costs for public debt by some $100 billion, according to SIFMA, a U.S. securities industry trade group.
The Federal Reserve and other bank regulators moved on Friday to reassure global markets that the downgrade would not mean that additional capital would be needed by banks and other institutions holding Treasury securities.
The Fed also said the cut would not impact the operation of its emergency lending window for banks, nor its buying and selling of Treasury securities to conduct monetary policy.
The impact of S&P's move was tempered by Moody's Investors Service's decision earlier this week confirming, for now, the U.S. Aaa rating. Fitch Ratings said it was still reviewing its AAA rating and would issue its opinion by the end of the month.
S&P's move is also likely to concern foreign creditors especially China, which holds more than $1 trillion of U.S. debt. Beijing has repeatedly urged Washington to protect its U.S. dollar investments by addressing its budget problems.
"China will be forced to consider other investments for its reserves. U.S. Treasuries aren't as safe anymore," said Li Jie, a director at the reserves research institute at the Central University of Finance and Economics.
One currency strategist, however, did not think there would be wholesale selling by foreigners.
"One of the reasons we don't really think foreign investors will start selling U.S. Treasuries aggressively is because there are still few alternatives to the Treasury market in terms of depth and liquidity," said Vassili Serebriakov, currency strategist at Wells Fargo in New York.
He said there was likely to be weakness in the U.S. dollar but a sharp sell-off was unlikely.
S&P had already placed the U.S. credit rating on review for a possible downgrade on July 14 on concerns that Congress was not adequately addressing the fiscal deficit of about $1.4 trillion this year, about 9.0 percent of gross domestic product, one of the highest since World War II.
But Obama administration officials grew increasingly frustrated with the rating agency during the debt limit debate and accused S&P of moving the goal posts in its downgrade warnings, sources familiar with talks between the administration and the agency have said.
The downgrade was immediately pounced on by candidates vying for the Republican presidential nomination. Mitt Romney said the move was "a deeply troubling indicator of our country's decline under President Obama," while Jon Huntsman said it was due to spreading of a "cancerous debt afflicting our nation."
The downgrade, 15 months before the next presidential election, and debt will be top campaign issues.