Politicians will likely cut a deal and raise the government's $14.3 trillion debt ceiling soon, but will need to tackle the underlying problem of narrowing gaping deficits in the long term, says Mohamed El-Erian, co-head of Pimco, the world's largest bond fund.
The White House has said that if Congress doesn't lift its debt limit by Aug. 2, it will default, and credit ratings agencies have said the country could lose its coveted AAA ratings.
"There are two distinct warnings here. Not one but two. The first warning if we don't get our act together in time, we will be downgraded. The second warning is even if we get our act together ahead of the debt ceiling but it doesn't involve meaningful, fiscal consolidation, then we will stay on negative outlook," El-Erian tells CNBC.
"And that second warning is really important."
(Associated Press photo)
What makes matters worse, El-Erian says, is that the closer the deadline approaches without a deal in place, the more toothless the likely compromise will be.
That means in just a few months, policymakers will be faced with a fresh round of fiscal emergencies and will spend more time putting out fires instead of tackling the underlying issues that plague the U.S. economy, namely hefty debts and gaping deficits.
"I buy into that we are somehow we are going to get through Aug. 2 without defaulting on the debt," El-Erian says.
"However, we've gone through this notion of a grand bargain to a notion of a mini-deal and now we are heading just towards as stopgap. A stopgap is the worst possible thing for both parties because it means that every three to six months we are going to have this issue again, and the market is going to have to price in an uncertainty premium, and that's not good news for any asset."
Investors need to factor debt uncertainty in the U.S. as part of what Pimco calls a New Normal, an extended period of high unemployment low growth.
That means more volatility awaits not only U.S. markets, but global ones as well.
"They have to recognize it's going to cause tremendous volatility, and they have to reflect in their portfolios that different countries and different companies are going to react differently."
Moody's has said it may cut U.S. ratings if a deal isn't reached.
While ratings agencies have warned of possible downgrades, Moody's was the first among the big-three agencies to actually place the United States' rating on review for a possible downgrade, which means a negative rating action is impending.
Analysts blame political grandstanding.
"What has been beginning to spook Moody's and some other people is that Congress may be dumb enough to actually default on the debt," says Cliff Draughn, President and Chief Investment Officer at Excelsia Investment Advisors in Savannah, Georgia, according to Reuters.
"When you've got Eric Cantor screaming no new taxes — you are not going to increase any revenue. You've got Nancy Pelosi on the other side of the aisle saying we will absolutely not cut any benefit of entitlement — Medicare, Social Security, etc. Then you've got (President Barack) Obama on the top saying everything is on the table. How do you rationally approach that type of situation?"
"I'm not surprised by what Moody's has done, it's the smart thing to do. They should have done it two or three months ago."
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