In 2011, the United States emerged from a damaging budget battle with a downgrade of its pristine triple-A rating for the first time in history. In 2013, it could be dealt even a bigger blow.
The battle over avoiding the so-called fiscal cliff is the first of a likely series of partisan confrontations in Washington in the coming year that, if not resolved, could cause more downgrades of the U.S. credit rating.
"The rating is in the hands of policymakers," said John Chambers, chairman of Standard & Poor's sovereign rating committee, the agency that downgraded the United States in August 2011.
In interviews with Reuters since the November 6 election, all three major rating agencies said cutting the U.S. debt rating - still among the world's strongest - is highly likely if next year's budget process replays 2011's debt ceiling debacle or if the seemingly simple goal of cutting deficits goes unmet.
Should that happen, it could have a detrimental effect on the country's cost of borrowing and could also shift some investment away from the United States, though the country's big markets and attractiveness as a safe haven are likely to limit those effects.
In the absence of a sustainable, coherent medium-term vision for the U.S. federal budget, which has produced deficits above $1 trillion in each of the last four years, the rating will fall. The fiscal cliff is one step in that process, but the possibility of a downgrade will still loom over Washington throughout the year.
"If no budget deal is reached in the early part of next year and the debt trajectory just continues to rise ... then we'd be looking at a downgrade of a notch to Aa1," said Bart Oosterveld, managing director at Moody's sovereign risk group.
Automatic spending cuts in January coupled with significant tax increases could take an estimated $600 billion out of the U.S. economy and push it into recession, according to the non-partisan Congressional Budget Office's assessment of the fiscal cliff.
The effects will be gradual, but significant, with the unemployment rate possibly rising to 9 percent.
If Congress goes over the cliff, Moody's said it will watch how the economy deals with the abrupt shock and will maintain the current negative outlook it holds on the United States.
Ultimately, if Congress and the president can't reach a deal to stabilize and eventually reduce the debt, now at $16 trillion, Moody's will probably cut the United States' current Aaa rating.
Fitch, meanwhile, said even a deal to avert the cliff might not be enough to save the country's AAA rating.
Temporary measures to stave off the budget shock without a credible strategy for the years beyond could earn the country a downgrade, said David Riley, managing director for sovereign ratings at Fitch.
"We're going to find out over the coming months if that (a compromise) will be the case or not," Riley said. "There isn't that much time."
The country needs a combination of increased revenue and reduced spending, Riley said. That plan needs to be bipartisan and credible over the medium-term, he added, calling a cliff-induced recession "wholly unnecessary."
Rating agencies will also be watching talks on raising the debt ceiling next year. S&P cut the United States to AA-plus from AAA on August 5, 2011, blaming bitter debt debates that threatened to plunge the country into default and Republican obstruction during a process that was for years a formality.
If the same happens this time, Riley said, Fitch could slash its rating during the first half of the year.
That could cause more turmoil for uncertain markets.
"The last time we faced this and the politicians played shenanigans with the debt ceiling and we were downgraded, it mattered in the sense that it led to a lot of volatility and a loss of confidence," said Julia Coronado, chief North America economist at BNP Paribas in New York.
BEST OF A BAD LOT?
When S&P cut the United States last year, markets reacted badly. The benchmark S&P 500 index <.SPX> slumped the Monday following, falling 6.7 percent to an 11-month low.
Paradoxically, U.S. Treasury yields plunged as spooked investors stampeded to safe havens. The yield on the benchmark 10-year note fell to 2.32 percent on August 8 from 2.56 percent on August 5 - and is now around 1.6 percent.
That same knee-jerk response could be repeated.
"Investors need to hold billions and billions of dollars," said Andrew Wilkinson, chief economic strategist at Miller Tabak & Co. "Where else are they going to go? Noise out of a rating agency is not going to change that."
That's particularly the case with the euro zone in continued turmoil. The area's three-years-and-counting debt crisis is still far from resolution.
"Certainly the dollar has no challenger as the key international reserve currency," Chambers said. S&P, having cut the rating last year, now could wait until the end of 2014 for another cut, Chambers said.
Investors will likely have plenty of time to digest a downgrade. Notably, countries that lose their AAA status typically take years to claw their way back to the top rating.
S&P downgraded Australia in December 1986, and it took until February 2003 for its triple-A to be restored. Canada took from 1992 to 2002. Denmark was cut to AA-plus in 1983 and didn't get upgraded back to AAA until 2001.
There's because sovereign cuts at the AAA level are relatively rare, coming on issues that take years to resolve.
"It's not really about the downgrade," said Jeff Rosenberg, BlackRock's chief market strategist for fixed income. It's about "what's occurring in the environment around that time period that's creating the momentum for the analysts to downgrade."
Still, there's a reason why countries lose top ratings only with difficulty. If the United States does indeed hold onto its AAA from Fitch and its Aaa from Moody's - and its one-notch lower rating of AA-plus from S&P - it could happen because the world's biggest economy proves its resilience once again.
"When you're looking at the U.S. from this side of the Atlantic, you say the outlook looks quite good compared to the UK and the rest of Europe," Fitch's Riley said.
U.S. gross domestic product is expected to rise at a 2.2 percent annual rate in 2013, compared with 0.3 percent annual growth in the euro zone and 1.1 percent in the United Kingdom, according to Thomson Reuters.
"If you can resolve this gridlock in Congress and provide some clarity, there's probably upside to the U.S. economy," Riley added.
Copyright @ Thomson Reuters 2012