Should USA still be AAA?

Despite soaring budget deficits, investors are still buying U.S. Treasurys. Still, some critics say the government debt isn't nearly as safe as widely assumed.

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By Chris Isidore, CNNMoney.com senior writer

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NEW YORK (CNNMoney.com) -- When the Federal Reserve announced last week it was buying $300 billion in long-term Treasury notes, the move was viewed as one of the safer bets the central bank has made recently.

After all, the Fed has either bought or announced plans to spend trillions of dollars on troubled mortgages and other types of questionable consumer debt in the past year. At the same time, the Fed has been loaning money to banks and companies that couldn't get funding elsewhere.

So the purchase of AAA-rated Treasurys, the highest credit rating that a bond can have, is probably the least risky thing the Fed can do these days.

Investors agreed: The prices of long-term Treasuries rose after the Fed's announcement, pushing their yields lower. (Bond prices and yields move in opposite directions.) Rates didn't even budge much Friday after the Congressional Budget Office raised its federal budget deficit forecast for this fiscal year.

But is the purchase of Treasurys really as safe an investment as it seems? Some think the U.S. may not be able to hold on to its perfect credit rating indefinitely considering how much money the Fed, Congress and the Treasury Department have thrown at the economy in their attempt to lift it from this recession.

"The only reason someone who bought a Treasury can get their money is that the government is able to borrow more money to pay them off," said Peter Schiff, president of brokerage firm Euro Pacific Capital. "It's impossible for us to just keep going deeper and deeper into debt."

Still, that seems to be exactly what the government will be doing. According to credit rating agency Moody's, the amount of U.S. Treasurys held by the public, including foreign governments, is expected to rise to $7.8 trillion by the end of the government's fiscal year in September, up from $5.8 trillion a year earlier.

What's more, Moody's predicts that this figure could increase to $9 trillion by September 2010, since the government is likely to take advantage of the current low rates to finance its various bailout efforts. The yield on the 10-Year Treasury is about 2.62%.

But strong demand for Treasurys does little to assure those who think there will be big problems ahead. Critics of federal spending worry that once concerns about the value of the dollar or the government's debt load start to turn, it will turn quickly, sending Treasury prices plunging and longer-term interest rates soaring.

"Anyone who buys a lot of [long-term Treasurys] now might be crazy," said Brian Wesbury, chief economist at First Trust Portfolios. "It's the biggest the bubble in the world."

Higher bond rates can have significant costs for the nation since it would drive up the price that the government has to pay to borrow money. And any increase in how much the government has to spend on interest payments could lead to a reduction in the amount of money available for other government spending.

Even President Obama acknowedged that risk when asked during an interview on "60 Minutes" on Sunday about the limits on how much the government can spend on various efforts to jump start the economy.

"The limit is our ability to finance these expenditures through borrowing," he said. "People are still buying Treasury bills. They still think that's the safest investment out there. If we don't get a handle on this and also start looking at our long-term deficit projections, at a certain point people will stop buying those Treasury bills."

With the U.S. dependent on foreign investors to buy much of its debt, maintaining overseas confidence in U.S. Treasurys is particularly crucial.

That's why when Chinese Premier Wen Jiabao said earlier this month that he had "some worries" about the safety of the more than $700 billion in U.S. Treasury debt his country holds, it got the attention of bond traders and government officials. Some experts think the Fed's move to start buying Treasurys was at least partly a response to Wen's remarks.

"Is that a coincidence? Hmm. I think not," said Kevin Giddis, managing director of fixed income at Morgan Keegan. "I think it certainly helped the Fed make its decision."

On Monday, however, Hu Xiaolian, a vice governor of the People's Bank of China, gave U.S. Treasurys a vote of confidence, saying that the bank will continue investing in that debt because it views the overall credit risk to be low.

Will rating agencies downgrade the U.S.?

So far, major credit rating firms such as Moody's and Standard & Poor's have yet to take any steps to lower the U.S. credit rating -- despite the increased spending and concerns about rising budget deficits.

Still, some smaller rating agencies have already lowered their U.S. rating. Egan-Jones Group actually removed the AAA rating from U.S. debt four years ago, well before the current crisis in financial markets prompted trillions in government bailouts.

"There is little doubt that the obligations of the U.S. government have risen faster than their means to absorb those obligation," said Sean Egan, the firm's managing director. "Hopefully this trend will be reversed."

Egan doesn't think there is much threat of the government defaulting on its debt. But he said that government policies will lead to a severe devaluation of the dollar, which could leave investors almost as bad off as a default.

The dollar moved sharply lower against most other major currencies following the Fed's Treasury announcement. The Fed also said last week it would be buying $750 billion in mortgage-backed securities. So that essentially means the Fed is printing more than $1 trillion to fund these purchases. That could spark inflation down the road.

Nonetheless, officials with Moody's and S&P defend their current AAA ratings for U.S. debt. They say that the U.S.' debt level as a percentage of gross domestic product and interest payments as a percentage of tax revenue are well within the range found in the other 17 nations that still have AAA ratings. Most of them are in Western Europe, which some argue has a worse banking and credit crisis than the U.S.

"If you rate U.S. sovereign debt as less than AAA, then there's probably nothing in the world that should be rated AAA," said David Wyss, chief economist for S&P. "To some extent you have to grade on the curve here."

Still, officials with S&P and Moody's say they are concerned about various U.S. debt ratios. They insist they wouldn't be afraid to lower U.S. ratings if the ratio of debt to the size of the U.S. economy or interest payments to government tax revenues become too great.

"We don't have a magic number," said Steven Hess, senior credit officer for Moody's. "But if at any point we became convinced that the debt and ratios would continue to grow, [a downgrade] is something we would consider."

But Egan argues that S&P and Moody's would be extremely reluctant to cut their ratings on U.S. debt. So if anyone is going to downgrade their opinion of the government's creditworthiness, it will be the marketplace that reacts first, not the agencies.

"People aren't stupid. They figure this out over time," said Egan. To top of page

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