By Steven C. Johnson
NEW YORK (Reuters) - Standard & Poor's threatened Monday to downgrade the United States' prized AAA credit rating unless the Obama administration and Congress find a way to slash the yawning federal budget deficit within two years.
S&P, which assigns ratings to guide investors on the risks involved in buying debt instruments, slapped a negative outlook on the country's top-notch credit rating and said there's at least a one-in-three chance that it could eventually cut it.
A downgrade, which would leave Germany and France with a higher rating, would erode the status of the United States as the world's most powerful economy and the dollar's role as the dominant global currency.
If investors start demanding higher returns for holding riskier U.S. debt, the rise in bond yields would crank up borrowing costs for consumers and businesses. That would threaten to hurt the economy as it recovers from the worst recession since World War II.
"This new warning highlights the need for the U.S. to take better control of its fiscal destiny if it is to avoid higher borrowing costs and maintain its central role at the core of the global economy," said Mohamed El-Erian, chief executive at PIMCO, which oversees $1.2 trillion in assets and has a short position on U.S. government debt.
Major U.S. stock indexes fell than 1 percent on the day. Longer-dated government bond prices initially fell but recovered to post solid gains as falling stocks took over as the main driver for price action in the Treasury market. Bond prices frequently trade inversely to stocks.
The dollar also rose as more immediate fiscal problems in Greece hurt the euro and supported some U.S. assets.
The cost of insuring Treasury debt against default at one point Monday neared a 2011 high, though it was well below lofty levels hit two years ago when fears of a double-dip U.S. recession raged.
The threat of a downgrade raises the stakes in the struggle between President Obama's Democratic administration and his Republican opponents in the House to get control over a nearly $1.4 trillion budget deficit and $14.27 trillion debt burden.
The White House last week announced plans to trim $4 trillion from the deficit over the next 12 years, mostly through spending cuts and tax hikes on the rich. Congressional Republicans want deeper spending cuts and no tax increases.
The deficit problem has become crushing since the financial crisis of 2008. Now for every dollar the federal government spends, it takes in less than 60 cents in revenue.
A budget deficit running at nearly 10 percent of output and expected to grow will likely further swell a public debt load that's already more than 60 percent of the country's gross domestic product.
"Because the U.S. has, relative to its AAA peers, what we consider to be very large budget deficits and rising government indebtedness, and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable," S&P said.
Even so, Austan Goolsbee, the top economist at the White House, downplayed S&P's move, telling CNBC Monday it was a "political judgment" that "we don't agree with."
DoubleLine Chief Executive Jeffrey Gundlach said Monday that the S&P warning "should serve as an effective cattle prod in pushing the politicians toward a program of spending cuts and tax increases."
"NOT THE END OF THE WORLD"
Some on Wall Street also downplayed the immediate impact.
"If a corporate entity had the same kind of unsustainable leverage problems, it would have been downgraded long ago," said Robert Bishop, chief investment officer of fixed income at SCM Advisors in San Francisco.
"But from the standpoint of the sovereign, being on outlook negative is not the end of world," he added. "Japan, for example, is a double-A credit."
S&P downgraded Japan's rating earlier this year for the first time since 2002, saying Tokyo had no plan to deal with its mounting debt burden.
But unlike the United States, almost all Japanese debt is held by domestic investors. That means the country need not depend on foreigners for financing.
Axel Merk, president of Merk Hard Currency Fund in Palo Alto, California, said Monday's warning was "a wake-up call that we need to do something in the U.S." S&P is "absolutely correct that this is something serious that needs to be addressed."
Moody's, S&P's main rival in the ratings business, also maintains a Aaa credit rating - its highest - on the United States.
For PIMCO, the world's largest bond fund, the picture had become bleak enough to prompt it to announce in February it had sold all U.S. Treasuries in its $236 billion Total Return Fund.
Bill Gross, PIMCO's chief investment officer, said he expected interest rates to climb, the dollar to fall and the United States to eventually lose its AAA credit rating.
The ratings agency said neither the White House nor Republican plan does enough to fix the shortfall, and the tension between the parties has cast doubt on whether they will be able to work together on a long-term solution.
"Looking at the gulf between the parties, it has never been wider than now," David Beers, S&P's global head of sovereign ratings, said Monday. "It takes a lot of political will to bridge this gulf."
A U.S. congressional report last week blamed ratings companies such as S&P and Moody's Corp for triggering the financial crisis when they cut the inflated ratings they had applied to complex mortgage-backed securities.
George Feldenkreis, CEO of Perry Ellis International, said that casts doubt on S&P's outlook.
The ratings agency "does not have the intellect or systems to judge the ability of the U.S. economy or political system to resolve its issues of taxation and needed budget cuts," he said.
Moody's put some issues of U.S. Treasury debt on watch for a downgrade in 1996 when the White House and Congress failed to extend the government's debt ceiling.
The two sides are heading for a similar showdown over the $14.3 trillion legal borrowing limit, which will have to be extended within weeks.
SOURING ON THE DOLLAR
The U.S. debt burden has grown exponentially after a housing bubble burst in 2007 and set off a world financial crisis that toppled several Wall Street banks, drove up the jobless rate and thrust the global economy into recession.
Governments around the world were forced to increase public spending to prevent their economies from lurching into an even worse depression.
The tactics helped spark a recovery but left the United States and other advanced economies, which were hit hardest by the crisis, with staggeringly large debt burdens.
Though it rose Monday, the dollar is down about 5 percent against major currencies in 2011. S&P's move, coupled with record low U.S. interest rates, will do little to make it more attractive, said Kathy Lien, director of research at GFT.
"Even though I don't think an actual downgrade would occur, in this very sensitive or vulnerable time for the U.S. dollar, it's enough to spook investors from holding or buying dollars," she said.
(Additional reporting by Richard Leong, Jennifer Ablan, Herb Lash, Al Yoon, Dena Aubin, Wanfeng Zhou and Frank Tang; editing by Frank McGurty)