Full Faith and Credit

With U.S. treasury debt falling out of favor with investors and raising the concerns of rating agency Moody's, are higher rates on the way?

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U.S. treasury debt, long considered the safest and soundest investment in the world, continues to lose status among global investors worried about the health of American public finances.

On Monday, credit rating agency Moodys warned that the U.S. and a handful of other nations are "substantially" closer to losing their Aaa credit ratings. The credit rating agency said that economic growth won't be enough to bring public finances in the U.S., U.K., Germany, Spain, and Nordic countries under control. If these countries want to preserve their Aaa credit rating, which allows them to borrow at favorable rates and helps them attract capital, they will have to undertake tough budget cuts that will test "social cohesion."

The Moodys report may be something of a wake-up call in Washington. Just last month, Treasury Secretary Tim Geithner said in an interview with ABC News the U.S. will "never" lose its Aaa credit rating because investors will seek out U.S. debt in uncertain times. In other words, as bad as the situation in the U.S. is, it is likely to be even worse outside the U.S.

The debt problems in Greece and Spain have grabbed most of the headlines, but public finances in the U.S. are a serious problem too. The U.S. ran a surplus as recently as 2001. Today it has a $1.6 trillion deficit that is comparable to 10.6 percent of the economy. That debt level that isn't so far behind bailout-bound Greece, where the debt is 12.7 percent of the economy.

A downgrade would be disastrous for the U.S., which benefits in many ways from its Aaa credit rating. The rating allows the U.S. to borrow at cheaper rates, which is critical to funding its huge deficit. If the U.S. loses that rating, its borrowing costs will rise and it will loose some of its borrowing capacity, which will have an impact on social policy and spending.

A pristine credit rating also attracts financial and intellectual capital to the United States, which promotes economic growth and facilitates business spending and investment. And since so many currencies and transactions are pegged to the dollar, the U.S. enjoys influence in setting global fiscal and monetary policy.

All of those benefits are a boon to businesses and households, which benefit from lower rates and relatively easy access to capital. And if the U.S. loses its Aaa credit rating, those benefits are at risk.

The prospect of a lower rating means fiscal restraints may soon play a larger issue for the Obama administration and other governments around the world, as they prepare budgets and agendas.

There already are signs in the financial markets that investors are losing comfort with U.S. Treasury debt. China has been a net seller of U.S Treasury debt for the last three months. Foreign investors bought a net $19.1 billion worth of long-term equities, bonds, and notes in January, down from $63.3 billion in December, according to Treasury data released today. In February, China directed reserve managers to divest riskier U.S. assets and hold on to only those with an explicit government guarantee.

As demand for U.S. Treasury debt and U.S. denominated assets falls, the price is already starting to rise. Longer-term interest rates are more expensive compared with shorter-dated maturities, reflecting worries that high debt levels will lead to inflation in the future. On February 17, the yield curve, the difference between long- and short-term rates, reached 3.65 percentage points, the highest level in 30 years.

If the U.S. loses its Aaa credit rating, the trend toward higher rates will accelerate. And it will be just that much harder to reverse.