There's a sigh of relief coming from Washington and Wall Street after lawmakers approved a tax-free deal allowing the U.S. debt ceiling to be raised and the country to avoid default.
But we're not out of the woods yet. The threat of a historically unprecedented downgrade in the U.S. debt rating could send interest rates higher and derail the fragile economic recovery.
"We're in unknown territory," says Josh Stiles, an analyst at IDEAGlobal.com.
The Budget Control Act of 2011, rubberstamped by the Senate Tuesday afternoon, includes at least $2.1 trillion in deficit cuts over the next 10 years and no new taxes. In exchange, Congress will raise the debt ceiling in three stages with an immediate increase of $400 billion and another $500 billion increase after September. The final increase, between $1.2 trillion and $1.5 trillion, will come by the end of the year.
The deficit reductions come in two steps. There's an immediate cap on domestic and defense spending that will reduce the deficit by $917 billion over 10 years. The next round will cut between $1.2 trillion and $1.5 trillion over the same period, will be determined by a bipartisan committee. Proposals are due by Thanksgiving, according to the bill, with a vote by Dec. 23.
US credit rating still vulnerable
While the deal struck in D.C. ends a protracted spectacle of political theater, it doesn't preclude a downgrade in the U.S. debt rating. All eyes will be on credit ratings agencies Standard & Poor's and Moody's as they judge if the budget cuts are deep enough to effectively reduce the country's deficit. Fitch Ratings confirmed the U.S. debt's Triple-A rating on Tuesday.
S&P had said on July 14 that it would consider a downgrade over the next 90 days of the Triple-A rating on U.S. Treasury securities if the deal didn't include at least $4 trillion in deficit reductions over the next 10 years. The current plan falls short of that.
Credit downgrade would jolt interest rates
"If there's a downgrade and it looks likely, it's quite easy to say that interest rates will go up," says Chris Christopher Jr., senior principal economist at IHS Global Insight. "And in the end there will be a lower demand for loans, so short-term funding costs will go up for banks."
The Securities Industry and Financial Markets Association predicts a downgrade will send Treasury yields up six-tenths to seven-tenths of a percentage point, driving up U.S. government funding costs by $100 billion per year.
That, in turn, will drive up mortgage rates and business borrowing costs, which both tend to track the yield on longer-term 10-year Treasury notes.
Homebuyers may also get hit with higher fees because Fannie Mae, Freddie Mac, the Federal Housing Administration and the Veterans Administration will be forced to swallow more expensive borrowing costs, says Guy Cecala, publisher of trade magazine Inside Mortgage Finance.
"Those four account for 95 percent of the mortgage market," Cecala says. And if short-term rates shoot up, homeowners with home equity loans and adjustable-rate mortgages may also feel pain.
It won't stop there, says Greg McBride, CFA, senior financial analyst at Bankrate.com. If businesses have to pay more to borrow, they will pass on increases to consumers. Rates on credit cards, auto loans and other personal loans will also rise, he says, while creditors may consider reducing or freezing lines of credit.
"It would be a modest increase in rates, not anything that would put a strain on household budgets," McBride says. "But it's the permanency of that increase that becomes a headwind for debt repayment and the overall economy."
And consumers seeking higher yields in savings accounts or certificate of deposits won't find them higher there, either, McBride says. Banks will be sitting on too much cash when no one wants to take out a loan or rack up debt.
These are not good scenarios, but McBride recommends that consumers keep a cool head and not make rash decisions with their money. He noted how investors fled the stock market in 2008 only to miss the rebound over the next year.
"A downgrade is not going to be fun," he says, "but it's important to not panic."