By Yali N’Diaye

WASHINGTON (MNI) – Standard & Poor’s recent action downgrading its
outlook on the U.S. government’s ability to repay its debt has added a
sense of urgency to the need to reduce the fiscal deficits and debt of
the country.

“Even an extended delay in raising the debt ceiling could lead to a
downgrade of the U.S. sovereign credit rating,” Matthew Zames, chairman
of the Treasury Borrowing Advisory Committee, warned Tuesday.

In a letter to Treasury Secretary Timothy Geithner, Zames stressed
that a delay could be “perceived as an increased indication of the
political inability to forge a compromise on essential long-term fiscal
reforms.”

He added that a prolonged delay could have a negative impact on the
markets “well before a default actually occurs.”

In fact, “a considerable degree of uncertainty already exists among
market participants given the severe and long-lasting impact that even a
technical default would have on the U.S. economy” by triggering another
“catastrophic financial crisis,” Zames said.

Hence the “urgent need to raise the statutory debt ceiling.”

Markets indeed are in a state of uncertainty and investors
expressed it through their allocation choices.

State Street Global Markets Tuesday reported that its Investor
Confidence index fell to 97.0 in April from 97.3 in March, led by North
American investors (-3.9 points), while European investors confidence
bounced back (+6.3 points). Asia declined 2.7 points.

“Recent signals suggesting that U.S. growth expectations for the
first quarter may need to be trimmed, coupled with ongoing concerns
about the resolution of fiscal deficits in both the U.S. and Europe,
have dampened enthusiasm for further equity risk allocations,” the
report said.

Flows reported by fund data provider EPFR Global also reflect
investors’ worries about the U.S. and European debt issues.

In the week ended April 20, “Developed Markets Funds posted
outflows for only the fourth time in the 16 weeks year-to-date as
inflation, debt issues, mixed first quarter earnings and the prospect of
significant policy shifts — the end of QE2, the implementation of Basel
III capital requirements — sapped investor appetite for this asset
class,” EPFR noted last week.

In the fixed income sector, “Concerns about U.S. sovereign debt
joined dollar weakness, the Eurozone debt crisis, inflation and the
quest for yield on the list of factors driving EPFR Global-tracked Bond
Fund flows.”

“Outflows from US-domiciled Money Market Funds hit a four-month
high reflecting the need to meet tax payments and, to a lesser degree,
investors’ lack of enthusiasm for dollar-denominated cash equivalents,”
the report also said.

“In addition to shaking the U.S. sovereign debt market, Standard
and Poor’s change in outlook sparked fears that the big ratings agencies
will take a harder line with municipal issuers,” it continued.

“Redemptions from U.S. Municipal Bond Funds, which were again
spearheaded by retail investors, jumped to an 11-week high as their
current outflow streak hit 23 weeks and over $27 billion,” it concluded.

In fact, Moody’s Tuesday said that muni rating changes over the
first quarter “point to tough year ahead for U.S. state & local
governments.”

The rating agency warned that 2011 could well be the “toughest year
so far for U.S. state and local governments since the beginning of the
economic downturn in 2008.”

“We expect downgrades to continue to exceed upgrades throughout
2011 for states and local governments and school districts as states
cope with the effects of weak revenue growth, significant spending
obligations, and the loss of federal stimulus funding,” said Moody’s
Assistant Vice President Conor McEachern.

“Local municipalities will struggle to maintain structural balance
in an environment of declining state aid, lower assessed valuations, and
fewer budgetary options,” he added.

In its latest investment outlook published Tuesday, bond investor
giant Pimco said, “Coinciding with the end of QE2 is the debate on the
federal debt limit.”

“The risk is that real rates suddenly turn sharply positive on
inflation or debt concerns, thus feeding a negative effect from the link
between asset prices and the economy,” the authors added, thus expecting
QE2 to end as scheduled.

Pimco has been reducing Treasuries exposure to favor credit
products such as corporates.

Government debt is also Morgan Stanley Smith Barney’s
“least-favorite segment of the bond market,” according to the Global
Investment Committee’ April meeting released Tuesday.

The Committee said that within its global bond allocation, it
“created an even larger underweight in developed-country sovereign
debt.”

However, Morgan Stanley Smith Barney did not cite sovereign debt
fears as a reason, but rather “the approaching end of the Fed’s QE2
program, rising inflation expectations and the ongoing global economic
expansion.”

The Committee proved upbeat on the ability of U.S. lawmakers to
reach a fiscal compromise that will put the country on a positive track.

First, Morgan Stanley Smith Barney’s outlook for the U.S. deficit
reductions actually improved when Standard & Poor’s assigned a negative
outlook to the United States.

Besides, “The news media has played up the differences between
President Obama’s plan and that of Republican House Budget Committee
Chairman Paul Ryan,” the report said.

“They will likewise do the same once the Senate version has been
announced,” it continued. “What we find significant, however, is that
everybody important in deciding fiscal policy is aiming in the same
direction,” that is reducing the deficits.

“Moreover, all three plans will have put health care entitlements
on the table,” the summary said.

Earlier Tuesday, U.S. Treasury Secretary Timothy Geithner addressed
the challenges facing the U.S. economy currently and voiced confidence
that a “credible strategy” for budget reform can be hammered out.

** Market News International Washington Bureau 202-371-2121 **

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