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Is US Debt Downgrade Inevitable?

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Democrats and Republicans will present their own version of budget cuts later in the day on Monday, but is the estimated $2.7 trillion in cuts being proposed enough to avoid a credit rating downgrade?

Credit watchdogs at Standard & Poor's have warned that unless $4 trillion in cuts are made, with long term sustainable fiscal policies to balance the budget, the US will lose its coveted AAA status within 90 days. Moody's said the same thing this month, only gave the US 12 to 18 months to get its financial house in order before getting dropped from the triple-A list.

US government debt is considered the safest in the world. A lose to triple A status would cause every money market and Treasury bond fund to change its covenants that, until now, require holding AAA rated debt only.

"You'll want to buy stock in a printing press company because if the US loses its triple A status, funds will be printing millions of notices to shareholders explaining the sudden and extraordinary change in its investment profile away from triple A debt and allowing for double A in their portfolios," says Ron Weiner, president and CEO of RDM Financial Group in Westport, Conn, a $600 million asset manager.

While the market is not pricing in a default on US debt obligations, it is definitely pricing in the likelihood of a downgrade.

Unless the US cuts the S&P target of $4 trillion, or around $2 trillion is cut with $2 trillion added to the ceiling until 2012, then the country will get downgraded, according to various scenarios laid out by Goldman Sachs in a July 20 report by their Investment Strategy Group titled "Down to the Wire: US Debt Ceiling Deadline."

Any short-term solution raising the debt limit by under a trillion dollars, or any worst-case scenario where the US Treasury runs out of cash to pay government obligations (exclusive of debt), would mean a downgrade by S&P.

"I think the markets are weighing the inevitable downgrade," says Vlad Signorelli, director of global research at Bretton Woods Research LLC, a boutique investment advisory that forecast Europe would stretch out the debt payments of Greece and Portugal instead of the short-term restructuring packages first used.

A ratings downgrade would have negative implications for debt issuers whose credit strength is directly linked to the federal government. This includes debt guaranteed by the federal government, like money market funds and bank CDs, and the obligations of government agencies like Ginnie Mae, Freddie Mac and Fannie Mae mortgage debt. A downgrade could limit investor demand for US Treasuries as fund managers rush to buy other triple A rated debt, or hard assets and commodities, mainly gold.

"There will be nowhere to run in a downgrade," says Weiner. "We have built up on the gold positions for a lot of clients from around 2% to 4%. Of course, if the debt deal looks good, then gold could suffer. This is like Y2K all over again."

A $4 trillion haircut to the US government's budget would reduce money for states and government services at a time when the economy is still hurting from the 2008 housing and credit crash. Some government departments could even be shut down, forcing layoffs at middle class income jobs. Cuts are unlikely to bode well for employment.

Moreover, a downgrade could conceivably cause banks to raise interest rates to attract investors. But who wants to raise interest rates in the middle of 9% unemployment, asks Signorelli. "Then on top of a downgrade, you would also get plenty of funds liquidating their positions in US money markets and bonds. It will be dangerous. The dollar is going to be weaker. The euro is going to improve because of the new debt restructuring deals being made. We'll get Italy refinanced next for 30 years. I think we'll avoide a default. Obama has a trump card and can declare a national emergency to pay debt and I think the electorate would be behind him. If it's a crappy agreement, the dollar goes lower and gold goes higher. If it's a good agreement, gold still remains high until the US economy and job growth starts looking better," he says.

Back in 1995, President Clinton vetoed the Balanced Budget Reconciliation Act. Many of the temporary funding measures expired without resolution on the broader budget, resulting in a government shutdown and nearly a million federal employees out of work. In January 1996, Congress voted to put 760,000 federal employees back on the payroll, which started the process of all federal employees eventually returning to work. Then, two months later in March, Congress raised the debt ceiling to $5.5 trillion. Today, congress is thinking of raising by around $2.7 trillion.

There was no sustained impact on market interest rates from the 1995-96 government shutdowns.

"A downgrade is worse than a technical default," says Joel Smolen, hedge fund manager at Axion Capital Management in California. "I can't believe the market has held up today as good as it has. I don't think investors have truly priced in this question: what if our credit rating is downgraded? A lot of fund managers will change their covenant rules. But a lot will not. There will be significant funds from around the world who will liquidate their positions in US bonds and money markets if we lose triple A status."

House Speaker John Boehner's  debt-limit plan would raise the ceiling by just $1 trillion initially and later by $1.6 trillion in 2012, according to a Bloomberg article.

Boehner's plan calls for $1.2 trillion in spending cuts in the first phase and $1.8 trillion in the second. A committee would be created to identify spending cuts and Congress would vote later on a constitutional amendment requiring a balanced budget. Meanwhile, Democratic Senator Harry Reide readied his party's proposal, which would give the president the full $2.4 trillion in additional borrowing authority he has requested -- enough to last through the 2012 elections -- and $2.7 trillion in spending cuts.