Negative outlook for the USA

S&P downgraded the US outlook to negative yesterday prompting a sell off in the stocks and rally in bonds. It was very volatile the action, Euribor spreads were going down in the fronts, and along the whole curve.
To be honest I'm glad they had the balls to take this action cause clearly there is huge debt burden in the US and just cause of their size and status shouldn't mean that they are immune to such actions or threat of such actions if they cant control their debt. It was this type of rating threat which prompted drastic action in the UK with many tough decisions taken by the government to lower the debt, it remains to be seen whether this level of commitment to lowering debt will happen in the US.
Here is 10 things you should know according to Barclays take:

1) Yesterday, S&P put its long-term rating on U.S. sovereign debt on negative outlook. This means that it believes there is at least a 33% chance that it will lower the AAA long-term rating of the U.S. within two years.

2) Its base case remains that U.S. policymakers will agree on a deficit reduction plan with savings of $4-5trn over the next 10-12 years. But importantly, S&P emphasizes that meaningful steps to implement this must start by 2013.

3) We believe this is an aggressive timetable, since it means that policymakers will have to agree on a long-term deficit reduction plan before the 2012 elections. This will be tough, given the political landscape and the structural nature of the budgetary problems.

4) According to S&P, the ratio of net general government debt/GDP would rise to 84% in the base case by 2013 (and 90% in a pessimistic scenario). Beyond the medium term, it views growth in entitlement programs to be the main source of fiscal pressure.

5) The catalyst for the negative outlook was the “increased risk” that there would be no resolution to “the medium and long-term fiscal challenges” facing the U.S. until after the 2012 elections.

6) In other words, once the two political parties put their deficit reduction plans on the table, it became obvious how far apart they were, and how difficult the road to political convergence would be. S&P noted that despite more than two years having passed since the financial crisis, there has been no agreement on steps to reverse the fiscal deterioration. It highlighted the examples of other countries such as UK, France and Germany, which have begun implementing plans to address their fiscal problems.

7) The announcement was seemingly a surprise to the bond market: 30y yields reversed their early morning rally, and the yield curve steepened immediately after the announcement. It was a surprise to us, as well. While we have always emphasized the unsustainable nature of the U.S. deficit and have outlined the likely factors that would drive a lowering of the U.S. AAA rating (see How risk-free are U.S. Treasuries? January 8, 2010), we had believed that the rating agencies would wait till after the 2012 elections before taking any action.

This announcement was not about the debt ceiling; in fact, the debt ceiling is not even mentioned in the S&P release. In sharp contrast, the reason why U.S. government ratings came under pressure in 1995-96 (Moody’s put parts of U.S. government debt on negative watch) was the debt ceiling impasse at that point. This means that even if the debt ceiling debate were to be resolved in the near term, it would not be enough to restore the outlook to stable.

9) On the other hand, the longer that debt ceiling negotiations drag on, the bigger the seeming rift between the two political parties and the greater the likelihood of a downgrade down the road. In turn, this would mean a steeper Treasury yield curve, higher yields on the long bond, narrower longer-term swap spreads, and a flatter swap spread curve.

10) The key to a stable outlook is that there be a concrete plan for deficit reduction that needs not only to be agreed upon, but also put in place by 2013. As noted earlier, this will be very challenging.