Negative S&P Outlook on Treasuries Reflects Poor Prospects for Political Compromise

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On April 18, Standard & Poor’s cut its outlook on the AAA rating of U.S. Treasury bonds to "negative" from "stable," saying the path from large fiscal deficits and mounting government debt remains unclear. The rating agency did not lower its AAA rating for Treasuries, and its change in outlook is the smallest move within S&P’s rating lexicon. A stronger step would have been to place the U.S. debt rating on "credit watch" with negative implications. Placing debt on watch indicates that S&P anticipates a significant, near–term shift in credit conditions.

Immediately following the announcement, Treasury prices fell but later rebounded amid optimism that the report could serve as a catalyst to force Democratic and Republican lawmakers to compromise on a solution. The prices of credit default swaps on U.S. bonds — essentially the cost of insuring against the government’s inability to pay interest — rose sharply but were still at levels well below those reached during the depths of the 2008–2009 credit crisis.

Concern about political gridlock

The move to a negative outlook means S&P believes there is a one–in–three chance that Treasury bonds could be downgraded from their AAA rating two years from now. The central issue for S&P is the risk that U.S. policymakers will not reach an agreement on a deficit–reduction plan until after the national elections in 2012. On April 13, President Obama presented his administration’s deficit–reduction plan, which relies on a combination of tax increases, changes to Medicare, and cuts in military and other spending to reduce the deficit by $4 trillion over 12 years. The Republican–led U.S. House of Representatives offered a plan that would cut the deficit by $4.4 trillion over 10 years by reducing the scope of Medicare and Medicaid, cutting non–defense spending, and lowering the top individual and corporate income tax rates. S&P views President Obama’s and the U.S. House of Representatives’ proposals as the "starting point of a process aimed at broader engagement." However, it is concerned about the sides reaching an agreement in the near term because the gap between the parties remains wide.

Moody’s — another major credit–rating firm — came to a different conclusion. After warning earlier this year that it might eventually place a negative outlook on U.S. Treasury bonds, in its Weekly Credit Outlook published April 18, Moody’s called the competing budget proposals a turning point in the debate and reaffirmed its stable outlook for U.S. debt.

Increased scrutiny may lead to meaningful structural reforms

We believe the move by S&P is more a commentary on the current political environment than a reflection of an increased risk of default at the federal level, which remains highly unlikely. With the Obama administration in the White House and a Republican–controlled House of Representatives, we agree with Standard & Poor’s analysis that there is unlikely to be any grand compromise on the most significant budgetary issues until after the 2012 election, at the earliest. Over the next 18 months, we are likely to continue seeing compromises between Democrats and Republicans on the margins — the passage of the 2011 fiscal year budget was one example and the pending negotiations over the federal debt ceiling will be another. But the structural reforms that are needed to keep Social Security, Medicare, and Medicaid solvent are unlikely to be addressed in any meaningful way before 2013.

As far as the implications for the bond markets, we believe increased downgrade risk won’t necessarily lead to higher Treasury yields. If European–style austerity measures were to be enacted (which we view as highly unlikely), lower growth could be expected, which would likely be accompanied by easier monetary policy over an extended period.

Many market–watchers are hopeful that the move forces politicians to get more serious about finding solutions to the government's ballooning deficit, and we tend to agree. The budget in general and entitlement spending in particular will no doubt be key issues in the 2012 presidential race, as both parties articulate their views on the future of these programs. That said, we believe there is little risk of the United States losing its AAA rating status even with political gridlock over the next several quarters.

Consider these risks before investing: Funds that invest in government securities are not guaranteed. Mortgage–backed securities are subject to prepayment risk. Funds that invest in bonds are subject to certain risks including interest–rate risk, credit risk, and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest–rate risk than short–term bonds. Unlike bonds, bond funds have ongoing fees and expenses.

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