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A U.S. Treasury Department employee holds a blank U.S. Treasury cheque before it's run through a printer in Philadelphia. (William Thomas Cain/Getty Images)
A U.S. Treasury Department employee holds a blank U.S. Treasury cheque before it's run through a printer in Philadelphia. (William Thomas Cain/Getty Images)

Rating cut almost certain for U.S. Treasuries Add to ...

Washington's debt standoff is bruising the U.S. dollar, fraying nerves in Ottawa and other capitals, and even beginning to hurt business operations as it nears the point of no return.

As the deadline to raise the U.S. government's debt ceiling draws closer, the warring factions appeared to be digging in even deeper Tuesday. And worries about the impasse are escalating as it becomes clear that rating agencies, notably Standard & Poor's, are likely to cut America's triple-A rating even if a last-minute deal is reached and a full-on crisis is averted.

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So far, the action has largely been contained to currency markets, where investors are fleeing the U.S. dollar for currencies that are deemed a safer bet, those like the Canadian dollar and the Swiss franc. The loonie briefly rose to $1.063 (U.S.) during trading on Tuesday, its highest point since November, 2007. But as tensions rise, there is a growing belief that this will soon spill over into stock markets, spooking equity investors who have so far been largely unfazed.

Businesses, too, are beginning to suffer. Executives at United Parcel Service Inc., which is considered a good bellwether of the American economy, cautioned that the debt dispute is prompting companies to maintain slim inventories and ship less. Montreal-based CGI Group Inc., meanwhile, warned that U.S. government contracts are being delayed.

Ottawa, which still believes a deal can be reached in Washington, is also growing nervous, particularly over the strength of the loonie, which the Bank of Canada has already said is a threat to the economy.

"We are always concerned with any rapid fluctuations in the Canadian dollar," Finance Minister Jim Flaherty said Tuesday. "… What we want to avoid, what is fundamental now, is any shocks, any more shocks in the world economy. We've seen enough of that in the past few years."

Until this week, most investors had shrugged off the political drama in Washington, and the threat of a default, assuming that politicians would ultimately compromise and strike a deal. But with each passing day, skepticism is growing that a solution will be agreed to by Aug. 2, which the White House says is the last day that the U.S. government will be able to borrow money if the debt ceiling is not raised.

That is sparking fear of the unknown. Because U.S. Treasuries have always been considered "risk-free" they are the benchmark by which interest rates are set for many different forms of debt, including corporate debt. A spike in the yields on Treasuries could cause higher borrowing costs for consumers and businesses, not to mention exacerbate the U.S. government's fiscal woes by driving up interest costs.

"Because Treasuries are used as a risk-free rate to price so much fixed income, it's hard to know where the ripples stop," said Dan Curry, president of DBRS, Inc., a Toronto-based credit rating agency.

From Wall Street to Bay Street to the City, economists are sketching out scenarios of what might happen next. But they are all educated guesses. "The collateral impact is impossible to identify in advance," said Bill Holland, chairman of CI Financial Corp., the country's biggest independent mutual fund company.

And it now seems all but inevitable that the U.S. will lose its coveted triple-A credit rating, regardless of whether Congress approves a higher debt ceiling in coming days. The only way to prevent the rating agencies from taking such action, which many debt watchers say is long overdue, would be a political agreement than brings in a credible plan to rein in the sky-high deficit through significant austerity cuts, tax hikes or some combination of the two.

"The S&P sword of Damocles is very much over our heads," said David Ader, head of government bond strategy at CRT Capital Group LLC in Stamford, Conn.

The question is how global markets would react to such an historic change in the perception of the U.S.'s creditworthiness. Not everyone believes it would lead to catastrophe. When S&P cut Japan's credit rating earlier this year for the first time in nine years and other agencies warned of possible downgrades, it barely caused a ripple in bond markets. Japan does most of its borrowing in its own market, its currency remains strong and safe-haven investors are not frightened off by its dysfunctional politics or deep-seated fiscal problems.

Will they react with similar nonchalance if the ultimate of global safe harbours, U.S. Treasuries, are hit with a similar rating cut? Mr. Ader says the answer is yes. "This is what fund managers will do: nothing."

But calm might not rein in the massive derivatives market, where T-bills are a common form of collateral. Some swap counterparties will likely have to get waivers to contracts that in some instances specify that those securities be triple-A, or they'll be forced to sell.

Canada lost its triple-A rating in the 1990s, and Australia in the 1980s, and both regained them after many years of hard work, noted Julian Jessop, an economist at Capital Economics. "A downgrade of U.S. government debt would not necessarily be disastrous for Treasuries or the dollar, at least once the dust settled," he wrote. "However, it would be the starkest warning yet that the fallout from the global financial crisis will still be felt for many years to come."

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