Tom Sowanick is Co-President and Chief Investment Officer of Omnivest Group, Princeton Junction, N.J.

While Washington is trying to avoid both a default and a credit rating downgrade by U.S.-based rating agencies, we remain concerned as to why they have waited this long to consider a potential downgrade. Nearly any other country that watched their deficits increase by over ten-fold over 10 years would have almost assuredly been downgraded early in the process.

In 2001, the U.S. sported a budget surplus of $127.3 billion and it is estimated that this year’s deficit will reach $1,650 trillion.
To put this increase in perspective, the highest deficit to GDP ratio (post the Second World War) was six percent in 1983. For the past three years, our deficit to GDP ratio has been above 10 percent. Despite all of the promises to reduce deficits, there appears to be very little willingness to actually take decisive actions by either party.

It is our belief that the U.S. will escape the near term problem posed by the debt ceiling with no more than a “selective” default at worst. However, we believe that a downgrade of U.S. Treasury debt is inevitable, and in some ways, the U.S. has already occurred.

Global investors have used the currency markets to display their displeasure towards the growing deficit problems in the U.S. Since the U.S. posted a budget surplus in 2001, the U.S. dollar has fallen by 39 percent. This decline is considerable, especially considering that the two largest holders of U.S. debt behind the Federal Reserve have been Japan and China. As a result, these large holders of U.S. debt have continued to expose themselves to dramatic currency losses.

It is understandable that foreign investors have been losing confidence in the U.S.’s ability to deal with its debt issue. China’s Dagong Global Credit Company initiated coverage of sovereign debt globally in July 2010, and downgraded the U.S. to a AA- rating and placed U.S. paper on negative watch.

In November 2010, this same rating agency lowered the credit rating of the U.S. again to A+ and left its credit rating on negative watch for further downgrades.

At some point, the U.S. rating agencies will begin to downgrade the debt of the U.S. government with obvious consequences to global investors. First, Treasury yields will adjust to a lower rating but the degree of adjustment is unknown. After all, we all know that Treasury yields have been held artificially low as a result of QE1 and QE2.

U.S. Government sponsored agencies will lose their implied AAA rating. Municipal debt which has been secured with Treasury securities will also see their values decline. Also, the Treasury yield curve should steepen, as long as the Fed keeps interest rates near zero.